Here’s The Deal For Homeowners

By Connel Fullenkamp

Monday, April 7, 2008

Note to Editors:
Connel Fullenkamp is an associate professor of the practice of economics at Duke.

Durham, NC -- Because of the desperate situation in the housing market, it is virtually certain that some kind of formalized bailout plan for mortgage borrowers will be adopted this year. But a taxpayer-subsidized bailout sets a dangerous precedent. It creates the expectation that the government will again ride to the rescue in the event of another housing bust. This could encourage another, even larger, bubble to form, to be followed by a worse crash and an even more expensive government rescue.

We seem to be left with a miserable choice: do nothing and face a downward spiral of foreclosures and falling prices, or rescue homeowners and create an upward spiral of speculation and bailouts.

One way to avoid both disasters is to design a program that will provide effective relief to mortgage borrowers while avoiding the giveaways associated with a bailout. Fortunately, there is already a way to do this, although it has never been used toward this purpose before. Its technical name is a "covered call option," but for our purposes here let’s call it "The Deal."

The Deal would be a contract between a homeowner and his mortgage lender that requires the lender to reduce the loan principal by, say, 20 percent. In return, the lender receives the right to collect a payment from the borrower on the date that the loan is completely paid off. The amount of this payment is determined by the difference between the market price of the house on that date and a reference price. The reference price starts out equal to the new principal amount of the loan, but grows over time as long as the borrower stays in the house and continues to make the payments on the loan.

For example, suppose the Smiths took out a $200,000 mortgage last June on a home that is now worth only $195,000. Under the terms of The Deal, Bank Uno reduces its mortgage to $160,000, giving the family more affordable payments. If the Smiths sell their home within the next year for $195,000, then they pay off their mortgage but also owe the bank $35,000 on The Deal. But if the Smiths stay in the house five years, Bank Uno raises the reference price to $180,000. Then if the Smiths sell the home for $195,000, they pay off the mortgage and owe only $15,000 on The Deal. They have earned $20,000 in extra equity simply by staying in their house and making their mortgage payments.

Requiring mortgage lenders to offer The Deal to borrowers who have little or no (or negative) equity in their homes would achieve the main purpose of a bailout, which is to prevent millions of mortgage borrowers from defaulting on their loans. The Deal gives borrowers the incentive to continue to make their mortgage payments, because they will earn a lot of equity by doing so. If they stay in their homes long enough, and the housing market fully recovers (which it always does, given enough time), then borrowers will still have the chance to enjoy capital gains on their housing investments. And this is no giveaway, because borrowers trade away part of their potential capital gains on their homes in return for an immediate reduction in debt.

Lenders also should like The Deal, because it converts a potential tsunami of defaults into at worst a dribble of losses. They give up part of the value of each troubled mortgage, but in return they get a big reduction in the likelihood of default now and the chance to recover their money later. They won’t have to report any profit or loss on The Deal until the home is paid off. Any realized losses would be partially offset by interest earned on mortgages that otherwise would have defaulted. And, equally important, the losses will be spread out over time, rather than occurring all at once. Dealing with small, recurring losses is a normal part of the lending business.

Best of all, The Deal won’t cost taxpayers a cent, now or later. But we need top regulators, starting with the Fed and Treasury, to persuade or require mortgage lenders to offer The Deal to homeowners who are in danger of defaulting. The government has been pressuring big players to arrange private deals to help each other out. Shouldn’t they do this for homeowners as well?