Leveraging the Disagreement on Climate Change: Theory and Evidence

Abstract

How do climate risks and heterogeneous climate beliefs impact financial mar-kets? We present novel theoretical predictions and empirical evidence from the mortgage market for properties at risk from sea level rise (SLR). We first develop a competitive search model of defaultable debt contracts with heterogeneous beliefs over future SLR, where property price, loan amount, repayment, and maturity are endogenous. Unlike existing two-period heterogeneous beliefs models, our infinite-horizon model allows for heterogeneity in maturity choices. In equilibrium, climate pessimists are more likely to leverage and to use longer maturity debt relative to optimists, trading their climate risk exposure to banks via long-term defaultable debt contracts. An expansionary monetary policy can induce more leverage by pessimists and make the mortgage market more vulnerable to climate change. We test several of the model implications using a comprehensive propriety data set of single-family home sales and associated mortgage contracts along the U.S. Atlantic Coast from 2001 to 2016. In line with our theory, we find that purchases of houses more exposed to SLR risk are more likely to be leveraged and tend to * The Federal Reserve Bank of Richmond; + University of Arizona. Contact: toan.phan@rich.frb.org. The views expressed here are those of the authors and should not be interpreted as those of the Federal Reserve Bank of Richmond or the Federal Reserve System. We are grateful for very helpful comments and suggestions from 1 use mortgage contracts with longer maturity, despite lower property prices (rel-ative to similar but less exposed homes); These results are driven by buyers from counties with more pessimistic climate beliefs, who are more likely aware of future climate risks. Our results highlight the importance of heterogeneous climate beliefs in understanding the effects of climate change on the financial system.