Reverse mortgage policies and market conditions in Spain, the United Kingdom, the United States, and Italy

Reverse Mortgage: Comparison of Spain, The United Kingdom, The United States and the Italy

The reverse mortgage is described as a "hot product" in the report of Fessler (2008) entitled: 'How Reverse Mortgages Could Help fund Your Retirement' since reverse mortgages "offer older investors a change to earn monthly income while they wait for the housing market to stabilize..." A reverse mortgage is defined as "...essentially a home quit loan that's paid out over time. Banks long ago recognized that some seniors approaching retirement were coming up short on monthly income, and the reverse mortgage was born...." (Fessler, 2008) Fessler states the following of the reverse mortgage: (1) it's a way to tap into a home's equity and receive a monthly check instead of making monthly payments; (2) the loan is paid back when the house is sold due to the owner moving or if the owner dies; (3) Most reverse mortgages have a minimum age requirement. In the case of Bank of America, it's 62 and older; (4) the upside to a reverse mortgage is that seniors can remain in their home, keep title to it and can continue to make improvements and basically do anything else one would do prior to getting a reverse mortgage." (Fessler, 2008)

The reverse mortgage, according to Fessler (2008) does not affect the various "entitlement programs such as Medicare, but Medicaid and other programs such as Supplemental Security Income (SSI) might be affected." The situation of a homeowner's tax may as well be affected by the reverse mortgage. In considering the reverse mortgage, the age of the individual is a factor and it is noted by Fessler (2008) that since people are living longer they should consider that the result would be that they would need "greater and greater sums to fund their retirement." Other factors to consider include whether the individual desires to stay in their home or sell and then buy another home or rent. Fessler does note that the reverse mortgage would be a good way "to receive additional monthly income while you wait for the market to recover." (Fessler, 2008) the downside is that the reverse mortgage "is - after all - debt dressed up as equity. And there's no free lunch: it eventually has to be paid back, either by you or your heirs." (Fessler, 2008)

I. OVERVIEW

The Peterson Institute for International Economics report entitled: "Germany and Italy: Mind the Accelerator!" states that Italy has a highly fragmented banking system "with extensive public-sector ownership, and limited alternative finance for companies and households" (Peterson Institute, 2007) the result is that "bank capital impairment is a very real risk and the supervisory system of Italy is "more centralized and likely will perform better than Germany's BarFin." (Peterson Institute, 2007) the property bubble in the United States is stated by the Peterson Institute to be nothing in comparison to the United Kingdom and Spain's and states additionally that "while direct property market spillovers are rare across borders, general liquidity reduction for real estate investment could hit these markets." (Peterson Institute, 2007) the Peterson Institute states that "Spain is at the greatest risk" and the United Kingdom is "at the least risk." (2007) the recovery in Italy are stated by the Peterson Institute to be unsustainable with Spanish real estate bubbles "significant" in nature. (2007)

II. POVERTY AMONG ELDERLY HOMEOWNERS

The following figure lists the poverty among elderly homeowners before and after home equity conversion in the countries of Spain and Italy.

Poverty among elderly homeowners before and after home equity conversion

Base income Imputed rent Moving Rev. Mortgage

Spain 32%

Italy 18%

Source: Lefebure, Mangeleer, and Bosch (2006)

Atkinson (0.5) inequality indices before and after home equity conversion

Base Imputed rent

Sale+Buy

Rev. mortgage

Spain 0.153 0.124* 0.138* 0.118*

Italy 0.165 0.152* 0.166 0.153*

Source: Lefebure, Mangeleer, and Bosch (2006)

The work of Lefebure, Mangeleer, and Bosch (2006) entitled: "Elderly Prosperity and Homeownership in the European Union: New Evidence from the Share Data" states that the "elderly population often combines low household income with high ownership rates" and additionally that the addition of a rate of return to home values "significantly reduces the poverty rates of the elderly, particularly in Southern and Central Europe." (Lefebure, Mangeleer, and Bosch. 2006)

The poverty rate is lower in the United States than in the UK where it is approximately 25%. In Italy the over 65 years of age poverty rate is lower as it is in the United States. The population in the country of Italy is reported as aging and it is stated that it is known from "basic life cycle theory (Modigliani) that saving and spending patterns change across the life cycle, with the propensity to borrow against future income in order to buy now declining significantly among the over 50s, and since it is increasing consumer credit that drives retail sales growth in the dynamic internal consumption economies, then it is highly likely that ageing will now act as a drag on sales growth in countries like Italy with very high median population ages (43, along with Germany and Japan). As we can see in the chart below (which comes from the U.S. Census Bureau database), Italy's median population age has been rising steadily, and at a very rapid rate (over 1 year's increase in median population age for each calendar year, of course historically this type of rapid ageing is quite unprecedented), with the only real substantial unknowns between now and 2020 being life expectancy, which may accelerate more than anticipated (in which case the population ageing will be even more rapid), and immigration, which will slow ageing down a bit." (Hugh, 2008)

Italy Median Ages

Source: Hugh (2008)

III. BANK of ITALY

In an address given by Ignazio Visco, member of the board, Bank of Italy at the 'Luxembourg Wealth Study: Enhancing Comparative Research on Household Finance' in Rome in July 2007 it is stated as follows: "As the assembling and standardization of national data sources is now complete, this LWS final conference marks the conclusion of the project. The next stage, as I understand it, will be the release of the LWS database to the research community. It contains a wealth of information on households' net worth and asset portfolio composition, as well as on demographic characteristics, consumption, expenditures and sources of income." (Luxembourg Wealth Study, 2007) Additionally stated is: "According to the Survey of Consumer Finances, the ratio of real assets to household disposable income in the United States rose from 3.7 in 1992 to 4.8 in 2004; in Italy, according to the SHIW, from 5.3 in 1993 to 6.3 in 2004. This is clearly a pattern shared by many other countries. On the other hand, net financial assets show a much more moderate trend. Overall, although time series of the aggregate level of household net worth still leave much to be desired (and the Bank of Italy is currently in the process of overhauling the estimation of Italian wealth figures, with results that will be presented in another conference later this year), there seems to be little question that over this long period wealth has increased at higher rates, for many countries much higher rates, than household disposable income." (Luxembourg Wealth Study, 2007)

Visco additionally states that there is the possibility that there: "...may be merit in considering the changes in shelter costs for owner-occupied housing as part of general consumer price changes. In this case, one should conclude that the prices of housing services have gone up substantially compared to other consumer goods and services. A part however, and possibly a significant part, of housing expenditures is clearly of capital-good nature. One should also then conclude that in these years house owners have been able to extract substantial rent from their accumulated real estate (and then the related questions would be: What determined the rent? Who has gained from the relative price changes? And at whose expense, at a country level and globally?).Anyway, in the first case we have an issue of relevance for monetary stability, in the second for financial stability, especially as house prices have been moving faster in relatively short periods of time and the larger house values have been used as collateral in financial deals. Clearly the LWS data could help substantially in answering some of these questions, comparing the experience of different countries and taking into account the presence of borrowing constraints as well as differences in house ownership. On the latter, it is striking to see how widely home ownership rates differ between countries: in 2000, while in the United States and in the United Kingdom about two households out of three owned their homes, in Germany, in the Netherlands and in Sweden the proportion was 40 to 60 per cent, in Italy about 75 per cent, in Greece and Spain 85 per cent." (Luxembourg Wealth Study, 2007) in summary, Visco states that homeowner statistics are as follows:

Country Homeowners

1) United States 33 1/3% of households

2) United Kingdom 33 1/3% of households

3) Spain 75% of households

4) Spain 85% of households

Visco relates that capital gains and losses on "on real and financial assets are also worth special attention from a macroeconomic perspective, however. This would be only natural for central bankers, as wealth effects may be a very relevant factor in determining fluctuations in aggregate demand. Studies on wealth effects have been conducted in recent years, also in the Bank of Italy, making use of household surveys. For a given level of net worth, the wealth effect may be defined as the extent to which household consumption changes in response to a change in asset prices relative to the general consumer price level. Conceptually, this is no different from the old Pigou effect, but while that worked through changes in consumer prices that reduced the "value" of money balances in real terms, we now have asset prices rather than consumer prices as the main factor. While consumer prices may be relatively stable, asset prices could move substantially, and the wealth effect could actually be a destabilizing rather than, as was once thought, a stabilizing factor." (2007) This results in a question of whether a "substantial drop in the relative price of houses might have a significant negative effect on aggregate demand." (Visco, 2007)

V. THEORY of MODIGLIANI

The work of Philippe Le Goff (2003) entitled: "The Reverse Mortgage: A Solution to Retirement Funding?" states that the theoretical basis of the reverse mortgage or the concept that underpins the reverse mortgage demand "is the consumption and savings lifecycle theory advanced by Modigliani in the 1950s." Or stated more simply the theory holds that "households accumulate a nest egg for retirement and use it to finance their retirement spending, thus cushioning the impact of the income drop that usually occurs at retirement. The theory involves two important assumptions concerning reverse mortgage demand:

1) Seniors living alone are more likely to participate in a reverse mortgage program; and 2) the appeal of a reverse mortgage program increases with age. (Le Goff, 2003)

Payment options are quite varied in the Reverse Mortgage plans and include:

1) lump-sum payments: The homeowner receives the full amount of the loan in a single payment;

2) Line of credit: The homeowner is given free access to funds up to a preset amount and can use them as he or she sees fit.;

3) Periodic payments: The homeowner receives payments for the duration of the reverse mortgage according to a schedule set out in the contract. (Le Goff, 2003)

Advantages of the reverse mortgage are stated to include:

1) Homeowners continue to live in their residence for the duration of the loan;

2) the property's value is likely to rise during the loan period, which reduces the actual cost of the loan;

3) the interest paid is tax-deductible if the reverse mortgage is used to earn investment income, such as interest or dividends. (Le Goff, 2003)

Primary disadvantages of reverse mortgages include:

1) Interest can accumulate quickly depending on the mortgage interest rate and the type of reverse mortgage chosen by the participant;

2) Due to associated fees, over and above the interest costs, the actual costs of the funds is higher than the cost of funds available from other instruments, such as a conventional line of credit;

3) if the property value does not increase much, the amount due upon disposition will be a large percentage of the selling price, which will reduce the net proceeds of the transaction; and 4) Heirs may end up with a much smaller inheritance. (Le Goff, 2003)

The work of Angus Deaton (2005) entitled: "Franco Modigliani and the Life Cycle Theory of Consumption" states that the theory of Modigliani was a theory of spending "based on the idea that people make intelligent choices about how much they want to spend at each age, limited only by the resources available over their lives." (Deaton, 2005) Modigliani is stated to have identified "one of the most important motives for putting money aside..." And that being "the need to provide for retirement." (Deaton, 2005) the life-cycle theory is one that holds that the "wealth of the national gets passed around: the very young have little wealth, middle aged people have more, and peak wealth is reached just before people retire. As they live through their golden years, retirees sell off their assets to provide for food, housing, and recreation in retirement. The assets shed by the old are taken up by the young who are still in the accumulation part of the cycle." (Deaton, 2005) Deaton states that the life-cycle hypothesis and its consistency with "the received theory of consumer choice is not only guaranteed its internal consistency, but also provided it with a generality that accounts for much of its durability." (2005) the theory in its original form provides a "specific account of consumption and saving, but it is derived from fundamental underlying principles that could be used to extend the model and to deal with a wide range of issues about consumption and saving, many of which had not been though about in 1950." (Deaton, 2005) Presently a key policy consideration is that of social security and while the role it plays is small "in the original formulation, the framework can be readily extended" to assist in the thinking about alternative policy consequences. While the methods and theories of economics have evolved over time and the enrichment and extension of the life cycle theory as have been witnessed were not "possible in the 1950s." (Deaton, 2005) Specifically, Deaton states: "Assumptions that were originally necessary for tractability have been relaxed. For example, Modigliani and Brumberg's original formulation recognized that life cycle planning requires people to look into an uncertain future, and that it is difficult to formulate theoretically satisfactory and tractable models of how people behave in the face of uncertainty. In the subsequent half-century, economists and others have developed methods for dealing with uncertainty, and economics has absorbed tools from the statistical analysis of time-series that enable us to handle expectations about the future in a more coherent way, and much recent work has been devoted to reworking life-cycle theory so as to rigorously incorporate an uncertain future. The tools were not available to undertake such a task in 1950." (Deaton, 2005)

Deaton relates that the work of Modigliani and Brumberg (1954) was primarily concerned with the cross-section or microeconomic implications of the theory, while Modigliani and Brumberg (1980) looks at the time-series and macroeconomic implications. For each individual, it is assumed (by appropriate assumptions about preferences) that increases in life-time resources lead to proportionate increases in consumption in all periods of life. As a result, consumption is proportional to lifetime resources or, what is more or less the same thing, to average income over the life span. Yet it was well-known prior to 1950, and it remains true today, that the share of consumption in income is lower for better-off households or, equivalently, that the saving rate rises with income." In fact, the data is stated by Deaton to illustrate "negative savings rates among those in the lower part of the income distribution." (2005) Furthermore, Deaton holds that it was these facts that "influenced the way that Keynes thought about consumption and his 'fundamental law' that consumption increased with current income, but not so rapidly." (2005) the argument stated by Modigliani and Brumberg (1954) was that the "proportionality of consumption and income in the long-run is entirely consistent with the cross-sectional facts because, as we move up the income distribution, a higher and higher fraction of people are there on a temporary basis, with high transitory income, and thus a temporarily high saving ratio. The same argument explains why savings rates rise more rapidly with income among households who are farmers or small business proprietors, whose income tends to be relatively volatile, and why, at a comparable income level, black families save more than white families. Black families have lower incomes than whites on average, so for a black group and a white group with the same average income, transitory income is higher among the former." (Deaton, 2005) Modigliani and Brumberg (1980) argue on the macroeconomic scale that "...for the economy as a whole, the saving ratio should be constant over the long-run (provided the rate of growth of the economy doesn't change), but will vary pro-cyclically over the business cycle. Over the business cycle, as over the life-cycle, consumption is smoother than income." (Deaton, 2005) in fact, the work of Modigliani and Brumberg (1954) and Modigliani and Brumberg (1980) basically state the same theory however the work in 1980 is stated to make "...a series of bold empirical predictions about the relationship in the aggregate economy between saving and growth and about the ratio of wealth to income in relation to the retirement span. It also develops a time-series aggregate consumption function, linking aggregate consumption to aggregate income, aggregate income expectations, and aggregate assets, with coefficients that are affected by, among other things, the demographic structure of the population." (Deaton, 2005) Modigliani presented comprehensive evidence on countries' savings and growth in his 1990 address to the World Congress of the Econometric Society, which demonstrates that "...both growth and demographic structure are powerful predictors of national saving, with little or no role for the level of national income, exactly as Modigliani and Brumberg had predicted 40 years earlier." (Deaton, 2005)

CONCLUSION

The lifecycle consumption theory posited by Modigliani in the 1950s has held over the past fifty years to be highly relevant in the planning that individuals undertake for funding their retirements years. This theory which holds that assets cycle through various stages of adulthood within the population upon the basis of the: (1) young; (2) middle aged; and (3) elderly has held true and produced empirical research findings supporting the truth in this theory.