Mr. and Mrs. Law wished for a more active retired life

  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?