MORAL HAZARD IN HOME EQUITY CONVERSION: Maintenance of Home

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The basic theme we are developing here concerns the nature of incentive effects caused when homeowners share the changes in value of their home with other investors. Consider a case where a homeowner shares half of a house’s value with an investor. Suppose the homeowner has the house on the market, but the house needs exterior paint which would cost $3000. Suppose the value for the house is $200,000 if the homeowner had kept up with painting the exterior. If the homeowner has not, the house will bring only $195,000 on the market. Therefore, the homeowner would rather not pay the $3000, since it yields to the homeowner only $2500. In contrast, if the contract were settled on the index rather than on the home price itself, then the homeowner would have a $2000 incentive to do the painting. To the investor, settling the contract on an index instead of the selling price of the house here entails half of a $5000 difference in return.


Now, many risk-sharing contracts with homeowners specify that the maintenance should be kept up for the contract, and the homeowners are subject to penalties if it is not. In practice, it may be very difficult to enforce such contract provisions. Consider further the house painting issue. The cost of hiring painters to paint a house varies considerably, often by a factor of two or more from lowest to highest price. One can hire high school students to paint the house, and not supervise them. This may result in a disaster-in-waiting, such a peeling paint if it is applied improperly. Or, it may result in spattered paint on roofing, floors, windows, and elsewhere, that may detract from the resale value of the house. Many houses have high resale value because they have been maintained exceptionally well, and this value may be easily lost even if the homeowner is technically in compliance with maintenance provisions of the contract.