## MORAL HAZARD IN HOME EQUITY CONVERSION: A Model of Moral Hazard for These Home Equity Conversion Forms 2

Finally, to compute the effects of the moral hazard on the investor, note that the sum of h(l) and the expected receipts Щ7) to the investor from loan balance and or sale of (share of) home is always equal to the expected value of the home ехр(ц + о112) +/(/) – D, and so IЦ/) = ехр(ц + o2/2) +/(/) -D-h(T). Thus, the expected shortfall s to the investor due to moral hazard as a function of the amount / that the homeowners choose to invest, as a fraction of the initial value of the home, is:

## MORAL HAZARD IN HOME EQUITY CONVERSION: A Model of Moral Hazard for These Home Equity Conversion Forms

Let us now suppose that there is a production function/(/) that converts investment expenditure I into home value.2 We interpret the term I very broadly as representing all costly activities that increase home value, not only the maintenance and improvements but also the efforts to get a good price at resale and the moral effort to refrain from under-the-table transactions. The homeowners attach weight a, 0 £ a £ 1 to the resale value, and (1 – a) to the value in use to the homeowners before sale.3 The expected profit for the homeowners in the absence of any risk sharing is given by:

## MORAL HAZARD IN HOME EQUITY CONVERSION: Graphical Representations 3

The same diagram Figure 2 applies to the situation of homeowners who have taken out home equity insurance on their home, to create a floor of value on the home. Doing this is the same as buying a put option on the home with a strike price equal to 80% of home value at the initial date, and borrowing 80% of the value of the home. That a portfolio of a home, a put option and a debt is the same as a call option on the home is due to the put-call parity relation in finance.

Figure 3 shows the case of a shared appreciation mortgage in which 75% of the mortgage value above the initial home value is paid to the mortgage lender, but all of the losses for the homeowner if the value of the home on resale is less than the initial value. This g(V) curve is a broken straight line with a slope of one to the left of V0 = 1, and a slope of ,25 to the right of V0.

## MORAL HAZARD IN HOME EQUITY CONVERSION: Graphical Representations 2

Figure 1, showing the case of a conventional mortgage, is very simple since we assume no bankruptcy. The g(V) function is just a straight line with a slope of one, and passes through the horizontal axis at point L If the final value of the home when it is sold equals L, then the homeowners get nothing at time of sale; the sales price is just enough to pay off the mortgage. If the value of the home should become less than the loan balance, then the homeowners have negative equity. In fact, some homeowners will declare bankruptcy under this circumstance, and so one might show the line as having a slope of less than one where V is less than L. Moreover, in nonrecourse states such as California homeowners can walk away from negative equity without bankruptcy. We disregard this complication here to provide a simpler contrast between the different risk management forms.

## MORAL HAZARD IN HOME EQUITY CONVERSION: Graphical Representations

For the purpose of understanding the incentives for moral hazard created by the various home equity conversion forms, we will summarize the incentives created for the homeowners by each of the various forms of home equity conversion described above in terms of their implied functional form relating the homeowners’ expected terminal portfolio value to the value of the home when it is finally sold. The date at which the home is sold depends of course on random factors: marriage, divorce, job changes, death, etc. For illustrative purposes, we disregard the uncertainty about date of sale, and assume that it is known, let us say, eight years in the future. Let us call g( V) the homeowners’ portfolio value as a function of the sales value V of the home on this date. In each example the portfolio is assumed to consist of the homeowners’ equity in the home (home value minus debt) plus any transfers created by the home equity conversion program. We assume that the homeowners are concerned about heirs, and so it is immaterial whether the sale is caused by death of an owner or for other reasons.

## MORAL HAZARD IN HOME EQUITY CONVERSION: Do These Moral Hazard Costs Really Matter?

Some providers of experimental forms of home equity conversion express blithe optimism that basing the contracts partly on an appraisal and making sure the homeowners have a fractional interest in the resale value of the home are adequate measures to deal with moral hazard problems.

## MORAL HAZARD IN HOME EQUITY CONVERSION: Selling of Home 2

Genesove and Mayer (1997) found that Boston condominiums with 100% loan to value ratio sold at prices 4% higher, after controlling for characteristics, than condominiums with 80% loan to value ratio, and stayed on the market 15% longer. Since homeowners with higher loan to value ratio have more incentive to get a good price, this appears to be evidence of the effect of incentives on selling behavior. Glower, Haurin and Hendershott (1997) find that people who say that their job has changed, thereby suggesting an urgency to sell, tend to sell for 11% less than do others.

New kinds of real estate brokerage arrangements are currently being developed: in addition to the traditional broker as representative of the home sellers, there are also buyers’ brokers and dual brokers. Law governing real estate brokers is being changed. We can never be sure that new seller-broker contract forms will be developed that may enable sellers to accept lower offers on their homes. For example, a new arrangement in which the buyers pay the broker’s fee, rather than the sellers, could cause the selling price to go down by the amount of the broker’s fee. Sellers involved in risk-sharing contracts may have an incentive to make such new arrangements. Arrangements can be made that make payments to brokers difficult to untangle.

Under-the-Table Transactions

With existing home equity conversion contract forms, the homeowners have a powerful incentive to hide some of the value of the home. There are very many ways that this can be done. The simplest thing to do is just to sell the home to friends or relatives at a below-market price. There could be an secret buydown from the buyers or a party connected with the buyers. Another way is to remove some advantage that the home has before selling it, such as replacing unique antique chandeliers with common reproductions.

Contract provisions requiring an appraisal of the property can prevent some of the most egregious examples of this. Still, there are potential problems, since appraisal is not an entirely objective science.

Homeowners can sell separately items that they might otherwise have included for sale, and they can refuse concessions such as homeowner warranties, redecorating allowances, or points or buydowns, or seller-offered financing, which would otherwise have boosted the price. There are very many different things that the seller can do to affect the selling price of the home, and all of these things would have to be addressed in a contract, lest they become serious costs for the investors who bear real estate risk.

Dealing with all of these problems creates costs for providers of home equity conversion.

## MORAL HAZARD IN HOME EQUITY CONVERSION: Selling of Home

Consider a home that is currently actually worth \$200,000 and the value as measured by the index is also \$200,000. The homeowners have already relocated to another city due to a job change and must cover all carrying costs themselves. Suppose the carrying costs of the home are \$2000 a month. Suppose the homeowners are offered \$190,000 for the home. They would figure that with a 50% equity interest in the home, this lowball bid would cost only \$5000. They would compare this loss against the possibility of having to wait two and a half months to get a bid of \$200,000. They might take the lowball \$190,000 bid and thereby cost the investor \$5000. If the contract had been settled on the indexed value of \$200,000, the investor would not be subject to this loss.

## A CHALLENGE TO STUDENTS OF EDUCATION AND SOCIAL SCIENCE: PROBLEM IN RESEARCH

They indentified 5 sources of research problem for students

1. Specialization-This is from an intensive search to reveal accomplishments of completed research in your area of specialization. One trys to find if there are problems which are yet unresolved. You may take up research in an identified area in order to highlight the recommendations for resolving or solving such problem. You may also see solutions to a problem another way.
2. Analysis of an areas of knowledge:- Divide a known area into sub parts and try to see if there are problems or gaps in knowledge identified. You can then find problem that is researchable by carefully examining the gap that exist in that area of knowledge.
3. Considering existing practices and needs; In education for example, gaps exist between principles and practice. A systematic analysis of existing practice and needs in particular , is a challenging intellectual exercise , whether the area examined is local , regional or national. The gaps in knowledge identified through a canvass should be viewed as challenges . You may include problem manifested in the actual practice
4. Repetition or extension of investigation ; History is never complete. Surveys of status can only be accurate within time and space. Under various condition a different laboratories results are bound to differ. One may therefore decide to repeat the investigation and write new report on it
5. “Off-shoots “of studies; if one looks at other research work done by scholars, you may see recommendation for further studies. Since research is cyclical or helical a new research starts when another ends

## A CHALLENGE TO STUDENTS OF EDUCATION AND SOCIAL SCIENCE: RESEARCH PROBLEMS

One of the ways of preventing students from being passive recipients of qualifies knowledge is by involving them in an active generation of knowledge through carrying out basic research (Amin, 2005). To see if students understand that education itself should be a source of problem solving for most societal problems a portion of the study periods (which is outside the course work) is marked out for research work by students. Problems are found everywhere in the world and most of these problems could be solved if they are properly investigated, solutions found guidelines for solving the problems stated, and recommendation made. One area of difficulty is problem formulation and stating the problem concisely and precisely in an understable way in the research