ESG is something of a prickly subject in the US securitization market. Perhaps it’s because vanilla, use of proceeds-based green bond frameworks cannot be so easily applied to asset-backed deals, but a particular skepticism is notable when talking ESG with structured finance market participants.
Some are merely doubtful that the labelling is useful, others believe there’s a lack of uniformity around how to apply ESG in the securitization market and a need for regulation. Others are more scathing that the concept can bring any true benefits at all.
“I think that ESG is a scam,” one securitization lawyer in New York told GlobalCapital last week. In any case, it is hard to avoid the feeling that most actors in US structured finance are not particularly bothered that progress is slow.
But, whether they like it or not, structured products buyers will soon come to realize that the “E” in ESG may be hard to ignore — especially when it comes to mortgage-backed securities.
For one thing, the increase in climate-driven risks on properties is already posing questions for investors. Natural disasters are already a risk for RMBS performance, for example, with hurricanes historically leading to higher delinquencies in residential mortgages.
Fitch noted in October, in the wake of Hurricane Ian — which is estimated to have caused economic losses between $60bn and $100bn — that delinquencies typically recover to pre-storm levels within 12 months. But, as NASA says, hurricanes are becoming both more frequent and more severe, suggesting that the impact will become more critical.
Indeed, some well known MBS veterans are so concerned about climate risk to portfolios that they now dedicate their professional lives to the topic. In 2019, David Burt and others founded DeltaTerra Capital to, in their words, “bridge climate science and investment science”.
It is only a matter of time before these risks start affecting credit performance more severely.
Skeptic squeeze
Many people believe that climate risks are overstated. Yet even if they are right and the scientists are wrong, the biggest skeptics in the market are going to be forced to confront ESG issues — as shown by recent developments in the regulation of the carbon emissions of commercial properties.
A Moody’s report this week analyzed 30 major cities in the US that had set carbon emissions reduction goals. It found that five municipalities are preparing to implement regulations that will use fines, five cities have incentives, and the rest are establishing goals to become carbon-neutral at different times.
For now, such fines are not going to destroy cash flow among CMBS deals, but could merely eat into it. Yet they encompass major jurisdictions. The three largest exposures to potential fines are New York, San Francisco and Washington, DC, which have a combined total of $191bn in outstanding balances in CMBS deals.
Darrell Wheeler, vice-president at Moody’s, told GlobalCapital that this is not likely to lead to default. But he said it would be more challenging for properties that are not performing well to comply with the fines.
As an example, by 2030 almost 3.3% of New York CMBS borrowers will face emission fines greater than 10% of their 2021 net operating income, and fines will be between 3% and 10% for another 11.8% of the loans, according to Moody’s.
Whether this particular regulation eventually becomes critical for CMBS deals is to be confirmed, but it is indicative of the direction of travel: mortgage-backed deals that do not pay attention to ESG aspects are vulnerable to finding themselves non-compliant with regulation as environmental concerns become more prominent among policymakers. This in itself can pressure credit performance.
The priority of investors, especially for those which have no explicit mandates to focus on ESG-compliant assets, is to ensure the highest possible returns.
But if the environmental factors start becoming legal liabilities or credit risk, investors will have no choice but to understand the significance of the “E” in ESG and start to pay attention.
And if US regulators truly push commercial properties to become more sustainable, with either penalties or incentives, then investors will be forced to understand how ESG-compliant collateral is — whether they are climate change believers or not.