Academic journal article Real Estate Economics

Moral Hazard in Home Equity Conversion

Academic journal article Real Estate Economics

Moral Hazard in Home Equity Conversion

Article excerpt

Robert J. Shiller [*]

Allan N. Weiss [**]

Home equity conversion as presently constituted or proposed usually does not deal well with the problem of moral hazard. Once homeowners know that the risk of poor market performance of their homes is borne by investors, they have an incentive to neglect to take steps to maintain the homes' values. They may thus create serious future losses for the investors. A calibrated model for assessing this moral-hazard risk is presented that is suitable for a number of home equity conversion forms: (1) reverse mortgages, (2) home equity insurance, (3) shared-appreciation mortgages, (4) housing partnerships, (5) shared-equity mortgages and (6) sale of remainder interest. Modifications of these forms involving real estate price indexes are proposed that might deal better with the problem of moral hazard.

Many of the forms of home equity conversion, both those forms that have already been implemented in some places and those that are just in the proposal stage, may result in some serious future losses for the investors. Participating homeowners may fail to take steps to maintain the value of their homes once they know that others are bearing some of the risk of poor home resale value. The risk of such future problems with home equity conversion might be reduced if the contracts were redesigned so that the settlements in them were determined at least in part by real estate price indexes, rather than only in terms of the sale price of the home itself.

We will refer to the failure on the part of the homeowner to take steps to maintain the value of the property when it is sold as moral hazard, in keeping with conventional use of that term, although in fact the word "moral" may be misplaced. Homeowners are presumed to be acting in their own self-interest, generally within the limits set by the law, though probably not quite the way that investors in home equity conversion forms would like. We use the term home equity conversion to refer to the objective of a number of plans that enable homeowners to convert their illiquid and risky investments in their own homes to other uses and reduce their exposure to real estate risk.

We will consider a number of home equity conversion institutions that can achieve risk reduction for homeowners, some of which have actually been implemented (though not on a large scale): (1) reverse mortgages, (2) home equity insurance, (3) shared-appreciation mortgages, (4) housing-market partnerships, (5) sale of remainder interest and (6) shared-equity mortgages. We will present a calibrated model of moral hazard, which allows us to reach some tentative conclusions about the magnitude of moral-hazard losses in each of these forms of home equity conversion.

All of these home equity conversion forms are potentially very significant, given the importance of housing in national wealth. According to the Balance Sheets for the American Economy produced by the Board of Governors of the Federal Reserve System, owner-occupied residential structures and land accounted for 25.9% of household wealth in 1994. For lower-wealth people, housing wealth figures even more prominently in their total wealth as they approach retirement [see Gustman and Steinmeier (1999) and Venti and Wise (1997)3 and is often almost their entire wealth at retirement other than social security. One would think that institutions that help people to manage the risk of such holdings would be very important. And yet, as of this date, none of these home equity conversion forms is very important in the United States or anywhere else in the world. While there are many reasons offered for their failure to thrive (see Mayer and Simonds 1994), concerns about moral hazard may be an important factor inhibiting t heir growth.

We shall propose modifications of the home equity conversion forms in which the risk reduction for the homeowner is achieved by tying payments, at least in part, to a home price index rather than to the value of the homeowner's own home. …

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