Harvard Professor Recommends Mortgage Principal Reductions

There have been a lot of ideas discussed to help ease the drop in home values over the last few years.  But despite all the discussion, these ideas have largely failed.  “Cash for keys,” foreclosure moratoriums, as well as government programs HARP, HAFA, and HAMP, have all helped fewer homeowners than originally planned, and home prices continue to fall.

So why the failure by both the government and big banks to stop the decline in housing prices?  Well, according to Harvard economics professor Martin S. Feldstein, it’s because none of these programs have addressed the root of the problem.  In a recent New York Time piece, Feldstein points out what most of us already knew.  The real problem is that the size of many mortgages exceeds the value of the homes.

Feldstein goes on to recommend a bailout of sorts…but not the same type of Wall Street bailout that we’ve grown so accustomed to over the last several years.  Feldstein says,

To halt the fall in house prices, the government should reduce mortgage principal when it exceeds 110 percent of the home value. About 11 million of the nearly 15 million homes that are “underwater” are in this category. If everyone eligible participated, the one-time cost would be under $350 billion.

The program would work by having the government (taxpayers) absorb half the cost, and the banks would absorb the other half.  For mortgages owned by Freddie Mac and Fannie Mae, the government would absorb the entire cost.  The program would be voluntary; if a borrower participates, he would have to accept that his mortgage would now be a recourse loan.  This means that the government could go after a borrower’s other assets if he defaulted.

Depending on the state and the type of loan, a mortgage may be recourse or non-recourse.  I assume that participation in this program would mean that a mortgage becomes a recourse loan regardless of state law.

This is an interesting plan, but it wouldn’t be without controversy.  Obviously, taxpayers who aren’t underwater on their mortgages might balk, but if the plan works, the affect on their home’s value would be positive as foreclosures decline.  For non-homeowners, the plan could offer indirect benefits via an overall positive economic impact.  But it is fair to banks and borrowers, at least according to Feldstein:

This plan is fair because both borrowers and creditors would make sacrifices. The bank would accept the cost of the principal write-down because the resulting loan — with its lower loan-to-value ratio and its full recourse feature — would be much less likely to result in default. The borrowers would accept full recourse to get the mortgage reduction.

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