Spare a thought – reverse mortgages

Skyrocketing home prices were ignored by the retired masses. With limited income and huge equity stored in their primary houses, thousands of retired home-ownders in the US and UK dipped into the equity in their houses.

Banks facilitated this through the creation of home equity release products or “reverse mortgages”. The bank lends money to the home-owner against the property as security. However, since the income of the “borrower” is limited, no interest payments are required. Instead, on death, the house is sold and the proceeds go first to repay the accumulated loan to the bank. The emotional trauma of having to sell one’s home is limited, no interest payments are required and the bank has another channel to route excess liquidity.

Bad selling practices and high effective interest rates gave these products a bad name. Sometimes the correct move, if difficult, is to downsize rather than rapidly erode the equity in a house. This tempered sales of the home equity release products that might otherwise have caused more headaches for banks given the current, twinned crises of credit and property.

The banks typically offered a “no negative equity” guarantee.  If the value of the house on death of the borrower was less than the outstanding loan, the bank accepted this hit to make the product more palatable to borrowers.  Careful management of loan-to-value ratios, property maintenance, borrower life expectancy, interest rates and expected growth on property is required to manage this risk.

Nowhere in these models was an allowance for property prices to plummet 12% in 2008 (in the US) and look to continue downwards.  12% is the average – positive house price growth benefits the borrower but declines put the implied put option further into the money. Thus, areas that have experienced 50% declines can severely hurt the banks with these guarantees in place.

These products has some legal difficulties in South Africa (mostly around the in duplum law that restricts the total amount owing to be not more than twice the original borrowed amount) and haven’t been as popular as many expected. Spare a thought for the banks with some of this on their balance sheets as property prices sink, loans accumulate and the far out of the money put options start to get their feet wet.

Published by David Kirk

The opinions expressed on this site are those of the author and other commenters and are not necessarily those of his employer or any other organisation. David Kirk runs Milliman’s actuarial consulting practice in Africa. He is an actuary and is the creator of New Business Margin on Revenue. He specialises in risk and capital management, regulatory change and insurance strategy . He also has extensive experience in embedded value reporting, insurance-related IFRS and share option valuation.

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