Martin Feldstein: How to Stop the Mortgage Crisis

Martin Feldstein has a plan to reduce mortgage loan defaults:

How to Stop the Mortgage Crisis, by Martin Feldstein, Commentary, WSJ: 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. ...

Limiting the number of ... defaults ... requires a public policy to reduce the ... value of mortgages. None of the current mortgage-reduction proposals are satisfactory. ... 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..., could ... 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...

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. ... 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. ...

The current possibility of widespread defaults is a cloud over all mortgage-backed securities, and over credit markets generally...

To lower the risk of a downward spiral of house prices and to revive the frozen credit markets, the government must move quickly to reduce the potential number of mortgage defaults. A loan substitution program may be the best way to achieve that.

Another solution that has been proposed is for lenders take "haircuts" on loans.... Richard Green says:

Should lenders take haircuts to stave off default?, by Richard Green: It is a tempting solution to the current problem: for those whose mortgage balance is greater than their house value, cram down the loan owed to the value of the house. This will presumably reduce the probability of default substantially, and losses will (largely) be borne by those who took on the lending risk. Ben Bernanke likes the idea, and he knows a lot more about financial crises than I.

But two serious problems stand out. First, future investors could respond by requiring higher spreads for mortgages. If these spreads get capitalized into values, the borrowers whose loans got crammed down could find themselves under water again, and the problem will remain.

Second, there is an issue of fairness. Consider two borrowers, one of whom has a 20 percent down payment, and the second of whom has a 5 percent down payment. If house prices decline by 10 percent, the second borrower gets debt forgiveness, while the first one doesn't. Perhaps the first casualty of financial crises is fairness, but as a policy matter, it is hard to ignore the problem.

I like Feldstein's idea better than the haircut proposal, though I can't imagine it actually happening and if it did I have no idea how many people would participate so it's hard to say if it would make a substantial difference. 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. Or am I missing something here?