Case Questions
In the context of the below examples:
1. How does adverse selection and/or moral hazard impact borrowers’ decisions to stick by the
terms of the loan when the reverse loan balance exceeds the market value of the house (due
to sharp declines in housing prices)?
2. Explore the moral hazard resulting from potential hesitancy of lenders to foreclose because
of reputational risk.
3. Explore the consequences of asymmetric information that the lender has regarding the
longevity of the borrower.
4. Explore the consequences of adverse selection and/or moral hazard on the borrower resulting
from high initial expenses.
5. Explore the nature of adverse selection and/or moral hazard resulting from tenure loan,
versus cash out?
6. How do the requirements of reverse mortgages mitigate adverse selection and moral hazard
risks for the lender?

MORAL HAZARD & ADVERSE SELECTION IN THE MARKET FOR
REVERSE MORTGAGES
Ittoop, V. (January 2021). Moral Hazard & Adverse Selection In The Market For Reverse
Mortgages.  (Unpublished.)

As the baby boomers approach retirement, there is growing concern that many have not
adequately prepared for their retirement.  Efforts are underway to promote higher savings and
adopt appropriate investment strategies for building retirement income.  Another approach is to
find ways to provide for retirement income from the assets retirees already have.
At a basic level, a reverse mortgage is a mortgage loan (from a finance company) that allows to
the homeowner (the borrower) to access income tied up in their home equity.  There are several
requirements for acquiring a reverse mortgage:
1. The borrower must be 62 years of age or older
2. The house must be the primary residence of the borrower.
3. The borrower must own the house outright, or have substantial equity.
4. Borrower’s income, assets and monthly living expenses are evaluated in order to determine
the ability of the borrower to maintain property, pay taxes and home insurance premiums.
5. The maximum that can be borrowed against the house is based on the appraised value of the
property, the age of the borrower and limits set by law.
6. Borrowers may choose to receive a lump sum payment (cash out), or monthly payments for a
fixed period (line of credit), or payments as long as they live in the house, sell the house or
die (tenure).
7. Borrowers must commit to maintaining the property and paying property taxes and home
insurance. Violations can result in foreclosure.
8. Heavy upfront fees are charged for acquiring a reverse mortgage and the borrower receives
reduced payments in the initial years.
With this basic knowledge, let’s consider the following examples.

Example 1
Profile:  Ms. Jones 63 years old and currently working. She estimates that her house would be
appraised at $250,000. Ms. Jones has total savings of $30,000 in her savings account.
Monthly take home salary: $3,750 Average monthly Property
Maintenance:  $400
Average Monthly Living expenses:
$2,800
Average Monthly Savings: $300
Monthly Home Insurance:  $100
Monthly Property Taxes:  $250

Ms. Jones is not financially shrewd. Hearing TV ads on Reverse Mortgage, Ms. Jones decide to
apply for a reverse mortgage at the local bank. Her objective was to grow her savings before
retirement, using the cash from the reverse mortgage payments.
Ms. Jones was given an estimate of total fees of $7,000 for a formal appraisal, title search,
insurance, underwriting, and other compliance-related expenses.  She was advised that the bank
would consider a reverse mortgage for only 52% of the appraised value, around $130,000 and
Ms. Jones would receive if approved, about $600 a month.
Decision:  Ms. Jones decided not to make the application for the reverse mortgage.  She felt that
the initial fees were too high and would eat away at her current savings.

Example 2
Profile:  Mr. and Ms. Martin are above 65 years of age. They are both retired.  They estimate that
their house would be appraised at $550,000. They have total savings of $250,000 in financial
investments.
Monthly social security: $4,000
Monthly Investment income:  $1,000
Average monthly Property
Maintenance:  $600
Average Monthly Living expenses:
$3,500
Average Monthly Savings: -$100
Monthly Home Insurance:  $400
Monthly Property Taxes:  $600

Mr. and Mrs. Martin received a brochure offering Reverse Mortgage and decided the contact the
lender. They hoped that the payments from the Reserve Mortgage would ensure a more secure
financial future.

They were given an estimate of $8,500 in fees for a formal appraisal, title search, title insurance,
underwriting, and other compliance-related expenses.  They were advised that the bank would
consider a reverse mortgage for only 52% of the appraised value, around $280,000 and if
approved, would receive, about $1,100 a month.
Decision: Mr. and Mrs. Martin decided to apply for the reverse mortgage, but was turned down
by the underwriter for negative monthly savings.

Example 3
Profile:  Mr. and Mrs. George is above 65 years of age. They are both retired.  They estimate
that their house would be appraised at $800,000. They have total savings of $650,000 in financial
investments.  Mr. George is healthy, but Mrs. George suffers from chronic health problems
Monthly social security: $5,000
Monthly Investment income:  $5,000
Average monthly Property
Maintenance:  $700
Average Monthly Living expenses:
$5,000
Average Monthly Savings: $2,600
Monthly Home Insurance:  $700
Monthly Property Taxes:  $1,000

Mr. and Mrs. George consulted a financial advisor regarding Reverse Mortgages. They explained
that although they are comfortable with their financial situation in retirement, they wished to
travel and enjoy some of their favorite activities more fully. They hoped that the payments from
the Reserve Mortgage would give them the extra cash to enjoy their retirement.
They were given an estimate of $10,000 in fees for a formal appraisal, title search, title
insurance, underwriting, and other compliance-related expenses.  They were advised that the bank
would consider a reverse mortgage of only 52% of the appraised value, around $420,000 and if
approved, would receive, about $1,800 a month.

Decision: Mr. and Mrs. George decided to apply for the reverse mortgage and received approval
for a tenure loan of $1,800.  They did not inform the lender of Mrs. George’s health problems.
Later, a combination of large medical expenses and a recession that depressed home prices
placed severe stress on their financial status.  They stayed on track with home insurance and
taxes but failed to maintain their property adequately.  The lenders delayed foreclose on the
Georges for fear of reputational risk.  Eventually, the Martins lost their home and moved in with
their family.

Example 4
Profile:  Mr. and Mrs. Law are above 65 years of age. They are both retired.  They estimate that
their house would be appraised at $1,000,000. They have total savings of $350,000 in financial
investments.  Mr. and Mrs. Law are healthy at the time of the loan application
Monthly social security: $6,000
Monthly Investment income:  $3,000
Other income: 5,000
Average monthly Property
Maintenance:  $1,000
Average Monthly Living expenses:
$8,000
Average Monthly Savings: $2,100
Monthly Home Insurance:  $1000
Monthly Property Taxes:  $1,900

Mr. and Mrs. Law wished for a more active retired life – more travel, more active social
gatherings, theater, etc. They hoped that the payments from the Reserve Mortgage would give
them the extra cash to more fully enjoy their retirement.
They were given an estimate of $12,000 in fees for a formal appraisal, title search, title
insurance, underwriting and other compliance related expenses.  They were advised that the bank
would consider a reverse mortgage of only 52% of the appraised value, around $500,000 and if
approved, would receive, about $2,000 a month.

Decision: Mr. and Mrs. Law decided to apply for the reverse mortgage and decided to take the
cash up front, rather than receive monthly payments.   They received $500,000 in cash.  After
five years of aggressive spending, they ran out of cash and became derelict in maintaining their property, paying taxes and insurance payments. Mr. and Mrs. Martin were given the option of
paying back the loan, or foreclosure.