In a previous column, I noted that large losses on HECM reverse mortgages could be attributed to adverse selection. The program attracts too many borrowers in desperate financial condition and too few borrowers with options.
I argued that HUD, instead of cutting the amounts that borrowers can draw, which could make the adverse selection even worse, should seek ways to make the program more attractive to homeowners who are not desperate, whose repayment record will be better. I proposed several initiatives aimed at that objective.
In this column, I'd like to look at the problem in a slightly different way. An insurer encountering adverse selection is mispricing the insurance. The price to its high-risk customers is too low and its price to low-risk customers is too high. On the HECM program, all borrowers pay the same premium rates: 2 percent of property value at closing and 0.50 percent of the loan balance monthly. The critical question, which a policy of charging different premiums to different borrowers requires an ability to answer, is how you identify high-risk and low-risk borrowers?
One plausible way to group HECM borrowers that might be related to risk of loss to HUD is by draw option. HECM borrowers select from the following menu of options:
• Tenure payments: Monthly payments for as long as they reside in the home.
• Term payments: Monthly payments for a period specified by the borrower.
• Cash at closing and after one year: On an Adjustable-Rate HECM.
• Cash at closing: On a Fixed-Rate HECM.
• Credit line: Against which borrower can draw at any time.
• Combinations: Any of the above excluding cash at closing.
The logical way to determine whether insurance premiums should vary with the draw option selected by the borrower is to compare loss rates on transactions grouped by draw option. Unfortunately, data on loss rates for different draw options are not publically available. What I am able to do is compare the ratio of insurance premiums collected from a borrower over the years to the growth of that borrower's debt. Other things being the same, a draw option that results in a higher ratio of premiums to debt should be lower risk.
I calculated this number for the first three options listed above, applicable to a 63-year-old borrower with a house worth $400,000. Over the first 10 years, the ratio of premiums to debt was highest for the tenure payment option. In later years, however, it was highest for the upfront cash option. The differences were not large enough or consistent enough to justify any inferences about insurance premiums. That awaits analysis of the issue by HUD using data on loss rates.
HECMs tied to annuities have gotten a bad rap
The HECM today is a stand-alone product. At an early stage in the evolution of the HECM market, some originators persuaded borrowers to use HECMs to fund the purchase of deferred annuities, but the practice was viewed as an abuse — originators looking to earn two commissions — and was shut down. HECM lenders today cannot disburse funds at closing that will be used to purchase an annuity.
That early episode left a residual prejudice against connecting HECMs to annuities, which is unfortunate. A borrower who uses a HECM to finance the purchase of an annuity may be a better credit risk than a borrower drawing a tenure payment. Borrowers who have moved to a nursing home have an incentive to conceal the move if they are receiving payments that cease when they become non-occupants, but they have no such incentive if they are drawing annuity payments that continue until death. Concealing a move-out can result in a longer period in which a house sits unoccupied, or occupied by non-owners with no interest in maintaining it.
HECMs integrated into retirement plans would carry minimal risk to HUD
HECMs that are part of a well-designed retirement plan should carry little risk to HUD because borrowers will not face impoverishment that leads to neglect of the home. HUD might be justified in imposing lower insurance premiums on such HECMs. A retirement plan can have numerous features, but the essentials for a homeowner are a portfolio of earning assets, a HECM and a deferred annuity. Given the rapid phase-out of defined benefit pension plans, furthermore, it should be public policy to encourage replacement plans to fill the gap. I will be writing about such plans in due course.
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.