MORAL HAZARD IN HOME EQUITY CONVERSION: Introduction 2

Reverse mortgages are contracts providing regular payments and/or a lump sum to the homeowner, the debt to be repaid only when the home is sold, the owner no longer lives in the home, or the owner dies. They are the “reverse” of conventional mortgages in the sense that, for many of them, the homeowner receives a monthly payment from the mortgage lender rather than makes a monthly payment to the bank, but their essential feature for us is that they involve some partial home price risk sharing for the homeowner. These reverse mortgages involve partial risk sharing for the homeowner because if the loan balance turns out to be greater than the value of the home when it is sold, the homeowner need not pay the difference. Reverse mortgages are loans against home equity only; they are subject to a non-recourse limit. They differ fundamentally from conventional mortgages or home equity loans for which loan applicants are required to show proof of income, and where the home is technically collateral. With reverse mortgages, no proof of income or wealth beyond the home is required, because the mortgagee has no claim on these.

The Federal Housing Administration sponsors a reverse mortgage program called the Home Equity Conversion Mortgage Insurance Demonstration Program, begun in 1989. Since this is a demonstration program only, there is a national limit of only 50,000 of these Home Equity Conversion Mortgages (HECMs). With the demonstration program, the risk that the mortgagee will have to absorb negative equity is ultimately borne by the government. There are also some private reverse mortgages, not insured by the government, such as the Home Keeper for Home Purchase program recently begun by Fannie Mae, and with these the homeowner’s price risk is shared with other investors. With conventional mortgages, in contrast to reverse mortgages, there is usually not the same risk sharing for the homeowner, since the homeowner is usually still required to repay the mortgage even if the home value falls below the mortgage balance. Here