Could Reverse Mortgages Become Subprime II?

CU360
December 3, 2009 | COMMENTS

Regulators that oversee banks were slow to recognize the threat posed by the boom in subprime mortgage lending, and slow to act. Now, the Office of the Comptroller of the Currency (OCC) is warning of danger growing in a market designed to serve the nation's seniors. “While reverse mortgages can provide real benefit, they also have some of the same characteristics as the riskiest types of subprime mortgages—and that should set off alarms,” said OCC Comptroller John Dugan this summer.

More than 100,000 seniors used reverse mortgages to tap more than $17 billion in home equity during 2008. Reverse mortgages continue to grow despite the economic downturn, with volume more than doubling between 2005 and 2008—and 2009 appears to be on pace for another record year.

The availability of reverse mortgages is good news for seniors who need to cash out some of their housing wealth to supplement Social Security, to meet unexpected medical costs, or to make home repairs. But growth in the reverse mortgage market also has unleashed more dangerous forces, according to the National Consumer Law Center .

Many of the same players that fueled the subprime mortgage boom have turned their attention to the reverse market. Lenders, including some of the nation's largest banks, view that market as a source of profits that have dried up elsewhere. Mortgage brokers see it as a new source of fees. And securitization, which allowed subprime loan originators to disassociate themselves from the downside risks of abusive lending, is becoming commonplace in the reverse mortgage industry.

Reverse mortgages are complicated and offer plenty of opportunities for abuse. Many seniors lack experience with complex financial products, and they frequently depend on lenders and brokers for expertise and guidance. Reverse mortgage lenders, like subprime lenders, often emphasize the benefits they provide to borrowers and tout their commitment to responsible lending principles—claims challenged by the Law Center .

In addition, reverse mortgage lenders have followed in the footsteps of their subprime counterparts by using financial incentives to reward brokers for arranging deals that boost lenders' profits and raise the costs paid by borrowers. By adjusting reverse mortgage loan terms such as interest rates, servicing fees, rate adjustment intervals, and distributions, brokers and lenders can maximize their profits at the expense of senior homeowners.

Seniors are also vulnerable to other abuses associated with reverse mortgages. Some have been persuaded to sink proceeds from reverse mortgages into complicated annuity contracts or expensive long-term care insurance products. These products generate large commissions for sellers, but frequently prove financially toxic for senior homeowners.

While counseling is required for all borrowers of federally insured reverse mortgages, only a handful of states require counseling for all types of reverse mortgages. And while quality counseling can be helpful to seniors, it remains inconsistent and underfunded.

Looking toward safeguards at the federal and state level to protect consumers from reverse mortgage abuse, the Law Center recommends:

• Creating product-suitability standards requiring lenders and brokers to arrange only deals that do not harm seniors' financial well-being.
• Strengthening borrower counseling.
• Banning yield spread premiums, which give brokers an incentive to make loans more profitable for lenders and investors at borrowers' expense.
• Regulating equity-conversion products that aren't federally insured and aren't subject to existing federal reverse mortgage regulations.

A $4 Trillion Target

The senior population is expected to grow rapidly, from 35 million in 2000 to 64 million by 2025. Seniors will also account for a growing share of the U.S. population—from 12% in 2000 to about 18% in 2025.

At first glance, seniors might not seem to constitute a rich market. In 2007, the median annual income of those age 65 or older was $17,382, or just under $1,500 per month. But as one study noted, “Residential real estate has grown to become the largest single asset class held by households with heads age 65 or older.” Over 18 million seniors own their homes. Approximately 15 million of those homeowners are potential reverse mortgage borrowers, including more than 12.4 million with no mortgage debt and 2.6 million with mortgage debt of less than 40% of the value of their homes.

Estimates of the amount of home equity held by seniors hold range between $2.8 trillion and $4 trillion. Even many of the poorest seniors have significant home equity available. In 2007, the American Housing Survey found that more than 700,000 seniors with annual incomes below $5,000 owned their houses free and clear, while another 2.4 million with annual incomes below $15,000 had no mortgages. All told, more than 7 million seniors with annual incomes below $30,000 owned their homes outright.

While reverse mortgage lending remains an industry niche, it's attracting the interest of banks, insurance companies, mortgage brokers, and Wall Street investors. Competition in the reverse market is heating up, with more than 2,700 lenders offering home equity conversion mortgages. More than 1,500 lenders originated their first reverse mortgages in 2008, according to a recent report from the Government Accounting Office.

The subprime debacle showed that loan originators too frequently sacrificed responsible lending in the name of greater volume, higher fees, higher interest rates, and more profits. Many industry analysts agree that the subprime bust resulted from lenders chasing volume by relaxing underwriting standards. And, notes te Law Center, the so-called “vigorous competition” among subprime originators was, in fact, a race to the bottom—a race that led to reckless lending on a massive scale.

The full report, Subprime Revisited, is available from the National Consumer Law Center, consumerlaw.org.