My article last week stated that
large losses on HECM reverse mortgages could be attributed
to adverse selection. The program was attracting too many of
those in desperate financial condition and too few of those
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.
This article looks 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% of property value at closing
and ½% 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?
Selected by the Borrower
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
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
Against which borrower can draw at any time.
Any of the above excluding 4.
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 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 3 options listed above, applicable to a borrower of 63
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
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.
Integrated Into Retirement Plans Would Carry Minimal Risk to