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.

In evaluating these claims, it should be borne in mind that the experience to date with experimental home equity conversion programs may not be a reliable guide to future losses. Firstly, with many of these forms losses take many years to develop, since home values change slowly. Secondly, the home equity conversion market is still in its infancy, and is not highly competitive. Profit margins have not been bid down to low levels, as can be expected to happen eventually. In a competitive market for home equity conversion contracts, small differences in revenues can spell the difference between success and failure for lenders or investors. Thirdly, the experience with the experimental forms of these contracts to date may not reflect the experience in the future when conditions change, when the pool of participating homeowners changes, when the national inflation rate changes, when homeowners learn more about how to play games against the investors. Thus, it is important to model the moral hazard in the abstract, to help us gauge its potential future significance.