Evaluation of the Reverse Mortgage Option in Hong Kong

• Author: June‐Sung Choi,Ping Wang,Hao Xu,Wei Han
• Date: 01 June 2017
• DOI: http://doi.org/10.1111/asej.12117
• Published date: 01 June 2017

Evaluation of the Reverse Mortgage Option in

Hong Kong

*

Wei Han, Ping Wang, Hao Xu and June-Sung Choi

Received 2 January 2016; accepted 16 March 2017

The reverse mortgage is a very useful financial product for senior citizens who own

homes but do not havea cash income, while it is a high-risk product from the lender’s

perspective. One of benefits of reversemortgages is that the debt limit is restricted to

the scope of the disposition price of the collateralized house, which is considered a

put option to borrowers. The present study evaluatesthe option value of the reverse

mortgage in Hong Kong through an empirical analysis using the Black–Scholes

option-pricing model. Moreover, the present study shows specific monetary values

through option matching to the consumer situation, contributing to the increased

understanding of reverse mortgages from the consumer’s point of view.

Keywords: Black–Scholes option-pricing model, option value, real option, reverse

mortgage.

JEL classification codes: C58, G17, G21, H55.

doi: 10.1111/asej.12117

I. Introduction

A reverse mortgage is a scheme where senior citizens with self-occupied houses can

receive fixed monthly instalments in the form of pensions. Reverse mortgages were

first established as a means to provide funding for senior citizens with no regular

income in aging societies, and have been used in developed countries, such as the

USA and Europe since the 1980s. The reverse mortgage is a long-term financial

product with many associated risks due to the uncertainty of the future (Chinloy

and Megbolugbe, 1994). In the process of operating reverse mortgage schemes,

financial institutions face the risk of falls in housing prices, increasing interest rates

and longevity of borrowers. However, if such risks are fully reflected in the loan

conditions, an increase in the loan rate and a decrease of the housing loan-to-value

(LTV)ratio become inevitable, causing a significant decrease in the effectiveness of

*Han: School of Economics and Management, Southwest Jiaotong University, No.111, First

Section, North of Second Ring Road, Chengdu, Sichuan 610031, China. Wang (corresponding author):

School of Public Health and Management, Weifang Medical University, No.7166, Baotong West

Street, Weifang, Shandong 261053, China. Email: wp19888@msn.com. Xu: School of Economics

and Management, Southwest Jiaotong University,No. 111, First Section, North of Second Ring Road,

Chengdu, Sichuan 610031, China. Choi: Audit and Inspection Research Institute, Board of Audit and

Inspection of Korea, 112 Bukchonro, Jonnogu, Seoul, Korea.

© 2017 East Asian Economic Association and John Wiley & Sons Australia, Ltd

Asian Economic Journal 2017, Vol.31 No. 2, 187–210

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a reverse mortgage. Therefore, many studies on reverse mortgages concentrate on

solving these problems. Miceli and Sirmans (1994) develop a theoretical model

to examine the issue of maintenance risk in reverse mortgages, because

homeowners have an incentive to reduce maintenance expenditures as their equity

declines during the reverse mortgage period. Chinloy and Megbolugbe (1994)

design a pricing model that considers factors such as the interest rate, housing price

volatility, a mortality coefficient and the inflation rate. Mitchell and Piggott (2004)

analyzes the methods for long-term forecasting of housing values and interest rates

to build an actuarial pricing model of reverse mortgages. Bardhan et al. (2006)

develop a redeemable reverse mortgage loan-pricing model based on the ideas of

European put options. Donald et al. (2013) conduct an empirical analysis of the

influence of house-price dynamics on reverse mortgage loan (RML) demand.

In contrast, a reverse mortgage is a very attractive product to consumers, because

they can receive funds to cover living expenses with almost no risk (Merrill et al.,

1994). As a home equity conversion mortgage is a government-insured reverse

mortgage, consumers can continue to own or use the relevant housing, regardless

of changing house prices, and can claim the difference at any time, if the house

price exceeds the total amount of the reverse mortgage loan when the contract is

terminated. However, if the total loan amount exceeds the house price, due to a

decrease in the price of the house, the borrower’s debt is limited to the scope of

the home value. Therefore, a reverse mortgage is a program that can be viewed

as a form of put option in which the home value becomes the underlying asset

and the total loan amount (total pension received) becomes the exercise price.

In the USA, the Home Equity Conversion Mortgage (HECM) program is

predominant (Case and Schnare, 1994). In Hong Kong, the Hong Kong Mortgage

Corporation (HKMC) has been operating the Reverse Mortgage Programme

(RMP) since July 2011. Since its implementation and up to 31 August 2015, a

total of 698 people had registered, 65.8 percent of which were single borrowers

and 35 percent two-person borrowers, with an average age of 69 years. The

average house price is approximately HK$4.9 million. The number of mortgages

is currently small, but it is constantly growing. Furthermore, many studies have

demonstrated that the implementation of reverse mortgages may greatly

contribute to a stable residential and elderly life (Kutty, 1998; Mayer and Simons,

1994a,b; Ong, 2008). Therefore, the present study will evaluate the option value

of the reverse mortgage operated in Hong Kong through an empirical analysis

using the Black–Scholes option-pricing model. Moreover, this study will show

specific monetary values through option matching to the consumer situation,

contributing to the increased understanding of reverse mortgages from the

consumer’s point of view.

The rest of this paper is structured as follows. Section II discusses the research

background on the structure and features as well as the actuarial models of reverse

mortgages. Section III presents the specifications of a reverse mortgage option

model and its selection of parameters. Section IV conducts sensitivity analyses

using conditions specific to the HKMC consumers according to the option model,

ASIAN ECONOMIC JOURNAL 188

© 2017 East Asian Economic Association and John Wiley & Sons Australia, Ltd