Wednesday, August 27, 2008

Feldstein on the Housing Market

Marty thinks he has a plan to keep underwater homeowners from defaulting without either burdening taxpayers or abrogating existing contracts.

I have proposed a programme of “mortgage replacement loans” that I believe would stop the downward spiral of house prices. The basic idea is to provide an incentive to stop defaults among those who now have positive equity but are vulnerable to a further price decline. The federal government would offer every homeowner with a mortgage the opportunity to replace 20 per cent of that mortgage with a low interest government loan – up to a loan limit of $80,000 (€55,000, £44,000) – that reflects the government’s lower borrowing rate. Creditors would be required to accept this partial mortgage pay-down and to reduce the monthly interest and principal by the same 20 per cent. That mortgage replacement loan would not be collateralised by the house but would be a loan that the government could enforce by lodging a claim on an individual who does not pay.

With the mortgage replacement loan, people who now have a mortgage equal to 90 per cent of their house value would see that mortgage fall to just 72 per cent of the house value, implying that it would take a very unlikely price fall of more than 28 per cent to push those individuals into negative equity.

Sounds like a free lunch? As far as I can tell, his "mortgage replacement loan" scheme involves tricking homeowners into accepting a deal that is not really in their self-interest. For very little in return, they give up the option of future default. So count me as skeptical.

But I agree with Marty when he says, "This is a difficult problem and there are no easy solutions."