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.
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?