Monday, 28 May 2007

Am me up, Pa

There is a lovely post today on the often insightful Calculated Risk on reverse mortgages. Here's the issue. Older people, particularly retired people, might have a valuable house but a low income. If they sell the house they take the risk that the funds raised run out before they die. What they need is an annuity like stream of income.

A reverse mortgage involves a bank making regularly monthly payments to a borrower as long as they live in exchange for a first lien on their property. The bank takes a combination of house price risk and mortality risk: if house prices go down then the eventual sale of the collateral will be lower than the value of the cash advanced; similarly if the borrower lives a long time then the interest payments create a substantial loss for the bank. Typically these products are structured as true mortgages so any excess of the eventual sale price over the amount needed to repay the loan belongs to the borrower's estate: the bank has the downside of higher longevity but not the upside of lower. Usually the notional principal of the loan is a fraction of the assessed value of the property so if mortality is high then the product is fairly safe. A combination of low mortality (increasing the duration of the loan) and falling house prices (decreasing the collateral value) can however be dangerous. There is also mortality dependent interest rate risk as you don't know how long to hedge rates for.

Note that combined asset price and longevity risk is one of the things that is causing problems in life insurance companies who have written annuities (or worst guaranteed return annuities) based on outdated actuarial tables and dud assumptions about asset returns. They too assumed that prices wouldn't go down and that people wouldn't live too much longer. Still, there's nothing like losing money in exactly the same way as the last guy, is there?
As Keynes put it:

A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.

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