An Interesting but Flawed Solution to the Mortgage Crisis

Martin Feldstein proposes and interesting though I believe flawed idea for resolving the mortgage crisis. Feldstein addresses a part of the crisis that most people don't understand. Many of those that are in trouble now owe more than their property is worth. This creates an extra incentive for them to default. The reason is simple. If you owe 225k and the place is worth 250k, you have a 25k incentive to make your payments. If on the other hand you owe 250k and your place is worth 225k, your only incentive is keeping your credit clean.

Feldstein's idea is to set up a new government program that would pay down 20% of the mortgage by giving the borrower a fifteen year loan from the government. There are several things I like about this program. First, it would be totally voluntary. The interest would be tax deductible and the borrower would prohibited from adding onto the mortgage after taking out this new loan. Other debts wouldn't be allowed to be paid off besides the mortgage. (thus borrowers would have less of an avenue to abuse the loan) Feldstein also proposes that the banks themselves administer payments thus eliminating the need for more bureaucracy, or at least more government bureaucracy. (This would likely increase bank bureaucracy to an even more obscene level and bank bureaucracy is no better than government bureaucracy) By doing this, borrowers would pay down the loan so that they owe less than their place is worth.

The problem is two fold. Feldstein proposes a fifteen year loan at adjustable rates mirroring the two year treasury bond.

The government would fund these loans by issuing new two-year debt and rolling over the debt until the loans are fully repaid, thus eliminating any net cost to the government. The government loans would not add to the budget deficit or to the net debt of the nation. Gross government debt would rise by the amount of the new government lending, but this would be balanced by the asset value of those loans.

Since Feldstein doesn't specify, I assume he believes this program would be available to all borrowers. If that is the case, the rate is far too low for the risk these loans would have. Feldstein's plan is to reduce the interest rate from each borrower's mortgage rate. If everyone is eligible then far too many bad borrowers would be getting far too low a rate. That means the creditor, the government, would be taking on borrowers that would default far too often for the rate they are being charged. This means that ultimately the tax payer would have to bail out the program because the defaults would be far too large for the interest rate charged.

Second, this would not help the borrower's monthly budget and in fact would make it worse. Most mortgage loans are installment loans. That means that no matter how much is owed the payment is the same. If a loan is taken out to pay off 20% of the balance, the monthly mortgage payment would stay the same. Now, the borrower would add the payment of the government loan on top of the mortgage. Struggling borrowers have enough trouble paying off the monthly payments they have. Feldstein just added another payment. This will only lead to disaster.

Ultimately the problem Feldstein and most folks have is that they refuse to acknowledge the truth. Most of these borrowers are bad borrowers. They don't need help but rather they need to be removed from these mortgages as soon as possible. What Feldstein and others are doing is the equivalent of rearranging the deck chairs on the Titanic. We aren't going to get out of the crisis by rearranging these folks mortgages into a new combination. The only way to get out of this crisis is to get them out of these mortgages, mortgages they frankly should never have been approved for in the first place, as soon as possible. As soon as everyone recognizes that truth, we will start to propose sensible solutions.