MORAL HAZARD IN HOME EQUITY CONVERSION: Introduction 5

We believe that many of these contracts that base settlements exclusively on the selling price of the homes are likely to reveal in many cases, at a later date, serious costs for the lender, costs that might have been avoided if the contracts had been written differently. With reverse mortgages, the contract could be restructured so that the homeowner maintains an interest in the home at all times, by rewarding/penalizing for departures of home price from the index value. With home equity insurance, the policy can be settled in terms of an index. With shared appreciation mortgages, the contract should be settled, at least in part, on a real estate price index for the region and housing type, rather than just on the selling price of the home. For housing market partnerships, the partnership contract should have special provisions so that the occupant of the home, the limited partner, benefits if the selling price of the home on sale is high relative to the selling price predicted by an index.

These contract provisions are critical because they encourage the homeowner to take steps to increase the value of the property, while not affecting the aggregate risk management properties of the contract. Without such provisions, we feel that, over long periods of time, there could be serious decrements to property value caused by the bad incentives. Many observers seem to think that the moral hazard problem is essentially “solved” if homeowners retain a fractional interest in the home. Our analysis suggests otherwise. Here

We consider here first some examples of the ways homeowners influence the sales value of their home, and of the likely incentive effects of home equity conversion. We then turn to a formal model of the effects of home equity conversion on incentives for all these different forms of conversion. Finally, we summarize the importance of alternative institutions that use index numbers in such a way that incentives are better maintained for homeowners.