By Richard K. Green (University of Southern California – Lusk Center for Real Estate) & Linna Zhu (USC Sol Price School of Public Policy)

This paper examines the feasibility of reverse mortgages in Japan by utilizing stochastic modeling to characterize the movements of three stochastic variables—interest rates, property values and mortality—underpinning the value of reverse mortgages. We use the yield curve to forecast future interest rates, taking into account the interest arbitrage condition and the term premium. We employ hedonic modelling to develop a house price index for Japan, and then use two times series method—Brownian Motion and Bootstrapping—to forecast house prices. We take the Japanese Ministry of Health, Labor and Welfare life expectancy tables to model mortality. We then integrate these three variables into our default risk estimation model in which we predict the magnitude of potential losses associated with default risk. Our simulation results show that home equity withdrawal rates matter significantly in determining the magnitude of tail risk and that line of credits plan and combination plans increase the feasibility of reverse mortgages in Japan. We also find that the increasing (50bps) risk premiums does not significantly increase the default risk (and of course allows for the buildup of a larger insurance fund). On the one hand, the risk premiums (or spreads) are set to capture the default risk and non-recourse risk. On the other hand, this hedging mechanism will in turn increase the default risk itself by ballooning the unpaid mortgage balance over time, thus generating an endogenous interest rate cycle.

Source: SSRN