Bhuyan, Reverse Mortgages and Linked Securities

We’ve all seen the ads for reverse mortgages, touted as a way for your house to pay you. Reverse mortgages are not especially tempting products; among other things, they normally have hefty closing costs. For most people they seem to be a last resort, not one choice among many. After reading Reverse Mortgages and Linked Securities: The Complete Guide to Risk, Pricing, and Regulation edited by Vishaal B. Bhuyan (Wiley, 2011) I begin to understand why.

First, a brief summary for those under the age of 62 who have never given a reverse mortgage a second thought (understandably, because they are not eligible). “A reverse mortgage is a longevity-linked loan that allows senior citizens, age 62 and older, to release the equity in their home without meeting any credit or income requirements. As opposed to traditional mortgages, there is no obligation to repay a reverse mortgage loan until the borrower passes away or no longer uses the home as a primary place of residence.” (p. 3) Almost 90% of reverse mortgages are Home Equity Conversion Mortgages (HECM), insured by the Department of Housing and Urban Development.

Reverse mortgages are inelegant structured products in an era of sophisticated financial engineering. First, securitization is problematical “because the nature of the cash flows generated by the asset is comparable to risky zero-coupon bonds with uncertain maturities. This means that the owner of the asset does not know what will be the value of the mortgaged asset at the unknown maturity date.” (p. 143)

Second, reverse mortgages use blunt pricing models. For example, although the most important variable in pricing a reverse mortgage is life expectancy, lenders simply use large-population actuarial tables in which not even sex is taken into consideration. The life expectancy of a 70-year-old woman who is healthy, physically fit, and comes from a demographic known for longevity is deemed to be identical to that of a 70-year-old man who has emphysema, diabetes, and smokes two packs of cigarettes a day.

Third, the lender, even with a contract in place, essentially has to hope that the senior citizen will maintain the house he is living in but no longer owns and that he will keep paying his taxes and homeowners insurance. “[W]here the senior is in direct breach of the loan agreement, the lender may be forced to remove the senior from his or her home. Clearly, the sight of a sheriff evicting a 75-year-old woman from her home does not sit well with anyone.” (p. 6)

The contributors to this volume analyze the current status of reverse mortgages, the main players in the market, and the ever-changing regulatory environment. They also suggest ways to enhance the methods of underwriting reverse mortgage loans so they will become more attractive to potential borrowers as well as to institutional investors.

The market for reverse mortgages should grow, given the demographic landscape. The question is whether the product can be fine-tuned in a way that is advantageous to both the individual and the institutional investor. This book is a first step toward that goal.