While it seems to me obvious, apparently it isn’t all that obvious. The first step in solving the subprime mortgage problem is to define what problem you’re trying to solve. In the Wall Street Journal today Martin Feldstein has a proposal for solving the problem:
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.
Although home owners may recognize that the national average level of house prices has further to fall, they do not know what will happen to the price of their own home. They will participate if they prefer the certainty of an immediate and permanent reduction in their interest cost to the possible option of defaulting later if the price of their own home falls substantially.
That’s the meat of the proposal but I encourage you to read the whole thing.
What problem is Mr. Feldstein trying to solve? Apparently, he’s trying to forestall a collapse in housing prices as a result of foreclosures causing the market to overshoot on the downside:
The potential collapse of house prices, accompanied by widespread mortgage defaults, is a major threat to the American economy. A voluntary loan-substitution program could reduce the number of defaults and dampen the decline in house prices — without violating contracts, bailing out lenders or borrowers, or increasing government spending.
The unprecedented combination of rapid house-price increases, high loan-to-value (LTV) ratios, and securitized mortgages has made the current housing-related risk greater than anything we have seen since the 1930s. House prices exploded between 2000 and 2006, rising some 60% more than the level of rents. The inevitable decline since mid-2006 has reduced prices by 10%. Experts forecast an additional 15% to 20% decline to correct the excessive rise. The real danger is that prices could fall substantially further if there are widespread defaults and foreclosures.
Will Mr. Feldstein’s plan solve that problem? It might—by subsidizing borrowers a little. And it might not depending on how much of the run-up in housing prices are a consequence of speculative fizz—that’s gone anyway. That’s the criticism levied by Megan McArdle:
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.
But the one thing it would definitely do is indemnify lenders against the consequences of their own folly. That’s the criticism levied by Arnold Kling:
It is hard for me to see this as anything other than a lender bailout. It does give borrowers a subsidy, based on the fact that the government can borrow at low interest rates. However, the main effect is to take risk off the table for lenders. They would immediately receive 20 percent of the outstanding balance on loans that are of high risk for default.
The problem I think is most in need of solving is the actual underlying cause of the problem which seems to me to be a problem with incentives in the financial services industry and the use of mortgage bundling and resale as a means of removing mortgages from the banking sector in which solvency, credit worthiness, and accounting standards are quite strict and regulated to the broader financial services industry which doesn’t receive nearly as much scrutiny. I don’t see that Mr. Feldstein’s proposal addresses either of those problems.
Mark Thoma brings up a point I thought of myself. Under Feldstein’s plan how would the government handle default?
There is one aspect he doesn’t mention. I’m not quite sure how the government avoids default risk without substantial loan collection costs, and even with aggressive and costly collection not all default can be avoided. I suppose the government could take future tax returns, Social Security payments, etc. in the case of default, but each additional restriction the government puts in place to protect itself will make the loans less popular and limit the program’s effectiveness. The government could also avoid any losses from defaults by setting the interest rate high enough (spreading the losses among borrowers), but the higher interest rate would also limit participation. In the end, it’s hard to imagine the government not taking some losses from this program, especially if participation is widespread, and the since the losses the government absorbs would be seen as some sort of bailout to lenders, the proposal would likely face political opposition.