The Asian edition of Wall Street Journal published an article on 3 June 2008 describing the ways that individuals in the USA employ to cope with the current economic downturn. These individuals are in their retirement years and their finances had not anticipated the hardship brought about by the credit crunch and the sagging economy.
Luckily for them, they live in the USA where financial ingenuity is encouraged and supported by a very robust legal system. One lady in her 60s was faced with mounting health care bills and her only source of income was a meagre social security check. To get out of a bad situation, she recently signed a life-settlement agreement with a company that buys life-insurance policies and other tough-to-sell assets. The lady had bought an insurance policy in 1997 and had been paying the premium ever since. The life-settlement agreement transfer ownership of the life-insurance policy to a third party, which then pays future premiums and collects the benefit. The lady received about $45,000 for her $250,000 term policy. Yes, she no longer has an insurance policy to benefit her children, but she gets to live a better life in her remaining days.
Similar schemes are available to persons who have won personal-injury settlements, which are often paid over a period of years. Investment companies offer to buy them out up front, for a sum much lower than the amount of the payments sold. Some may call this an exploitation, but I would not mind having an option to consider when I am at my wit's end.
Then there is reverse mortgage. A home owner that enters into a reverse mortgage agreement can get a lump-sum loan, a line of credit, periodic payments or a combination thereof. In exchange, the home owner agrees to sell the house to repay the loan, which becomes due when the borrower leaves the home for more than one year or dies. Fees and costs can add up to as much as 5% or 6% of the home value, but it is an option available to home owners.
Home owners have another new means of raising cash in the USA. A San Francisco real estate investment company called REX & Co launched a new product last year. It gives homeowners a cash payment, typically about 13% of the home's value. Upon a sale of the home, or the owner's death, the company takes as much as 50% of any change in home value during the time the agreement was in force. The investment company is taking a chance on the future prospect of the housing price, and they rightly should be compensated for taking that chance. Whether the cut is fair enough should be decided by the homeowner based on their individual circumstances.
Some people may complain that these schemes are taking advantage of people in distress. As I implied earlier, an agreement can only be reached by two willing parties. The availability of other options must be part of the equation in evaluating the scheme by the participating parties. The morality of the schemes, to me, is nothing more than a red herring.
Unfortunately (in my view anyway), such schemes are unlikely to be available in countries with poor legal infrastructure, since these are new financial products and hence participants can be harrassed by frivolous law suits. For example, relatives of the lady who entered into a life settlement agreement may challenge the validity of the agreement on the grounds that the new beneficiary of the insurance policy is not related to the insured. Their challenge may or may not have legal merits, but in countries with weak legal system (e.g. delays in processing the case in court, contradicting verdicts by different courts etc.) will discourage any investor from initiating such deals.
Even in a country with sophisticated legal system like the USA, new financial products can still face legal road blocks. A few years ago, we invested in an instrument called viatical, which is similar to life settlement, except that the insurance policies that we purchased belonged to critically ill patients. Mid way through our investment, the company that managed the product for us was closed down by the US SEC, because it was not properly registered with the SEC. However, since the US has a sophisticated legal system, orderly return of invested funds, minus legal fees, was made to investors in a relatively short period of time. Imagine if this happens in a less legally developed country. Still, some investors lost all of their investment in the instrument, since the instrument requires the investors to continue paying for the premiums of the transferred life insurance policies, and if the insured outlives the original life expectancy, or seem likely to do so, the investors may want to limit their losses and bail out, losing the value of the original investment.
Human ingenuity gives us the capability to solve many problems, including financial ones. Whether the solutions can come into being, however, often relies on the existence of institutional support such as the legal system and care in the product design to anticipate likely problems. Those who have the support and care will leave those who don't further and further behind in the race of economic growth.
[Chiu Ying Wong, CFA, 5 June 2008]