Let us consider the kinds of modifications that could be made in the home equity conversion contracts analyzed to reduce or eliminate the moral hazard problem created by the contracts, and consider how well these modifications are likely to work.
1. Reverse mortgages. As discussed above, the reverse mortgage contracts might specify that the homeowner is penalized for deviations of the home selling price from the value predicted by the index and the original selling price. This penalty provision can be made operative merely by indexing the debt to the real estate price index.
Even if we do not change the loan to value ratio, keeping it at 80% say, such indexation of debt in reverse mortgages may drastically reduce moral hazard by reducing the probability that the price of the home will fall below the indexed loan value. At the same time, indexing the debt to the real estate price index yields the additional benefit to the homeowner that the reverse mortgage policy achieves a risk management objective for the homeowner, protecting the homeowner against any impact from aggregate real estate market fluctuations.
To analyze the effects of indexing the loan balance to the real estate price index, we can use the same framework as shown above, and merely reducing the estimate of a, so that it reflects only relative-price noise of the house, not the full noise. Of course, moral hazard risk is not completely eliminated unless there is no chance that the market value with perfect maintenance, v, can fall below the indexed loan value.