ESG investing — that is “environmental, social and governance” money management — goes by many monikers. Some call it “sustainable investing,” others “impact investing.” The United Nations, which coined the term two decades ago in the wake of the Enron and Exxon Valdez scandals, sometimes refers to it as “inclusive investing.” All these phrases imply that capitalism can consider factors outside of quarterly earnings when making investment decisions.
Others are less sanguine about the movement. Unfettered free market advocates view it as misguided. Elon Musk has used his Twitter megaphone to call ESG “the devil incarnate.” Recently, the Financial Times, while pointing out that the term “ESG” was mentioned in almost 20% of corporate earnings calls last year, simultaneously said ESG’s ambiguity has set it up for a “reckoning.”
Rhetoric aside, here are some facts
The Securities and Exchange Commission has begun the process of developing mandated disclosure regimes for funds that consider ESG factors in their marketing material. Millennial and Gen Z investors have been voting with their wallets, demanding that ESG-like items are incorporated into investment decisions. The market has seen a major increase in corporate board focus on the issue, as well as investment funds offering ESG products.
Consider how much the estimates of dollar-based ESG assets range — from tens of trillions to nearly a hundred trillion — depending on the source. This massive variation demonstrates the current market’s inability to successfully quantify (or even define) what exactly we mean by those three magic letters.
Where is ESG investing going next?
What does ESG’s growth and current ubiquity mean for residential MBS markets?
When thinking about ESG in RMBS, right now there are three considerations that can help the mortgage market properly capitalize on the momentum behind the ESG movement. If done responsibly, ESG and RMBS should coexist in a positive, self-reinforcing, meaningful way, and one that establishes the residential mortgage market as a best practices leader in the movement overall.
To get there, first, Residential Mortgage-Backed Security (RMBS) issuers, investors, and rating agencies should avoid trying to boil the ocean. The E, S and G components are all very different, and at times unwieldy. Sometimes these factors are in outright tension with one another. Is affordable housing construction that requires trees to be torn down a social good, or not? Care needs to be taken so that the market doesn’t bite off more than it can chew.
The RMBS market should break ESG factors down and analyze them one at a time. Environmental (E) metrics are currently the most advanced. RMBS issuers and investors analyze not only environment hazard risks, like homes being in flood or wildfire zones, but also collateral features that have a positive environmental impact like solar panels. Data like the percentage of loans in a pool with LEED or Energy Star certifications, for example, are also good places to continue building a market.
The residential MBS market can also build from some of the infrastructure that already exists for the “S” – social – component of ESG. Ginnie MBS, for example, could be included in funds that focus on social impact, as they typically pool mortgages to borrowers with little credit history or needing down payment assistance. Same with “first-time homebuyer” flagged mortgages.
Where the market can get a bit more forward leaning would be with ideas such as a first-generation homebuyer flag, a measure of the proximity of affordable housing to public transportation, or whether new affordable housing will help a community meet its suggested/required affordable housing level.
Other ideas include more disclosure to investors around borrowers who received down payment assistance or are below a certain Area Median Income (AMI). These are all data elements that could be collected at origination and passed along to investors, and they fit nicely within the scope of how the market already operates today. The market should begin requesting these types of data flags from issuers and begin collecting and disseminating the needed data to ESG-focused investors.
Market participants must remember that, as fiduciaries, asset managers must tether all decisions to returns unless an investment mandate specifies otherwise. Certainly, ESG factors that analyze the sustainability of an asset do impact the fundamental value of securities. But for mortgages, the market can also be looking at ways to enhance pricing on MBS that offer both ESG components and improved, or at least more predictable, yield. Think, for example, of the reduced convexity of low balance loans.
Building out disclosure around low balance pools – reporting on whether they constitute underserved markets, low-to-moderate income (LMI) borrowers, neighborhoods that had historically been redlined, etc. – while also showing that the reduced refinance elasticity benefits investors and lowers rates to borrowers is a perfect place for RMBS to grab hold of already established practices and enhance them with ESG investing in mind. For a market already sophisticated in taking borrower factors into account for prepayment speeds and credit risk, looking at places where more details about homeowners can help both convexity risk and enhance underserved access to credit is an obvious win.
Next, RMBS market participants must understand that disclosures are going to be the key to success. The RMBS industry needs to work together to develop ESG disclosures that are as consistent and transparent as possible. One thing the recent raids at Deutsche Bank or fines against BNY demonstrate is that authorities are actively policing any accusations of “greenwashing,” ensuring ESG claims don’t get ahead of reality (see my previous comment on the market’s failure to consistently measure ESG assets). Sound data disclosure standards are the solution.
ESG investing means a lot of things to a lot of people. Maybe it’s the way eight billion people can share a planet and enjoy equitable and sustainable long-term growth. Maybe some of it is too amorphous to last. But considering how investments impact our world in the long-term is a very worthwhile goal, and one that many RMBS investors are seeking.
For the RMBS market to embrace the opportunity in front of it, building from what we already do well and staying laser-focused on transparency and data disclosure are the most important ingredients right now.
