Marty Feldstein, the former head of the National Bureau of Economic Research and a fearsomely brilliant economist, has a modest proposal for solving the housing market problems:
Optimists note that homeowners with negative equity have generally been reluctant to default in past years. That was sensible when house prices were rising. But with house prices falling, defaulting on the mortgage is the rational thing to do.
Limiting the number of such defaults, and preventing the overshooting of price declines, requires a public policy to reduce the number of homeowners who will slide into negative equity. Since house prices still have further to fall, this can only be done by a reduction in the value of mortgages.
None of the current mortgage-reduction proposals are satisfactory. Although bankers sometimes have the incentive to reduce mortgage-loan balances voluntarily in order to avoid a foreclosure, this is usually not possible because the syndication of mortgage loans means that there is generally not a single lender who can agree to the mortgage writedown.
Proposals to force creditors to accept write-downs of interest or principal violate their contractual rights, reducing the future availability of mortgage credit and raising the relative interest rate on future mortgages. Reviving the depression-era Home Owners' Loan Corporation would have the government use taxpayer money to pay off existing loans and become the largest mortgage lender in the country. This would require an enormous federal bureaucracy of appraisers and loan agents.
If the government is to reduce significantly the number of future defaults, something fundamentally different is needed. Although there is no perfect plan, a program of federal mortgage-paydown loans to individuals, secured by future income rather than by a formal mortgage, could reduce the number of mortgages with high LTV ratios and cut future defaults.
Here's one way that such a program might work:
The federal government would lend each participant 20% of that individual's current mortgage, with a 15-year payback period and an adjustable interest rate based on what the government pays on two-year Treasury debt (now just 1.6%). The loan proceeds would immediately reduce the borrower's primary mortgage, cutting interest and principal payments by 20%. Participation in the program would be voluntary and participants could prepay the government loan at any time.
The legislation creating these loans would stipulate that the interest payments would be, like mortgage interest, tax deductible. Individuals who accept the government loan would be precluded from increasing the value of their existing mortgage debt. The legislation would also provide that the government must be repaid before any creditor other than the mortgage lenders.
Although individuals who accept the loan would not be lowering their total debt, they would pay less in total interest. In exchange for that reduction in interest, they would decrease the amount of the debt that they can escape by defaulting on their mortgage. The debt to the government would still have to be paid, even if they default on their mortgage.
Participation will therefore not be attractive to those whose mortgages that already exceed the value of their homes. But for the vast majority of other homeowners, the loan-substitution program would provide an attractive opportunity.
I tremble to disagree with Feldstein, who is about a zillion times smarter than me. But I think he overestimates the problem of people walking away from homes where the loan-to-value (LTV) ratio is above 100%--i.e. where homeowners have "negative equity". Letting a bank foreclose is a traumatic action that will scar your credit report for almost a decade; most people do this, not when a decline in the value of their house reduces their equity, but when they can't make the payments. I see the problem of foreclosures largely as one of people who took out loans they couldn't afford, not owners behaving strategically about a depreciating asset. And preventing some foreclosures will not, I think, stop prices from declining.
The main problem in most housing markets seems to be, not foreclosures, but the simple fact that people are no longer under the delusion that house prices will go up 5-10% per annum. In 2005, people were pricing that into their housing purchase: "Well, it's worth maybe $300,000 to me, but of course, in three years, the house will be worth $450,000, so I could pay $375,000 and have a nice nest egg." Now that the expectations of asset-price inflation are gone, prices have to fall back to the "real" value of the house: what it is worth to someone to have a warm, dry abode of their very own to live in. Actually, a little farther, because the credit contraction means that there's a large mismatch between supply and demand.
Foreclosures might cause the price collapse to overshoot on the downside, but I don't see them as the primary driver, even in depressed markets.
That said, this is not a bad idea. It would give some breathing space to people who can't make their interest payments right now--particularly if the money is used to pay off the first, more expensive loan. I'd think that even people who were upside-down on their mortgages would want to take advantage of this, and assuming a relatively low rate of default, it's not particularly expensive--the government is loaning out money at the rate it borrows. I don't think it would halt the price declines, but it would prevent some foreclosures, and help other people get their finances together without letting them escape the consequences of borrowing money they can't afford.
This probably means, of course, that it has actually no hope of ever making it into law.
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