TCS Daily

A Plan to Address Troubled Mortgages

By Arnold Kling - September 5, 2007 12:00 AM

I suspect that the widespread panic over potential mortgage defaults is due less to the magnitude of the underlying problem than to other factors. One factor is that August was a slow news month. Another factor is that many people root for bad things to happen in the American economy, and they get revved up when anything goes wrong.

Nonetheless, it appears that mortgage defaults are the crisis du jour and that politicians will now fall over one another to do something about it. Under those circumstances, let me suggest an approach that I have not seen elsewhere: a debt-for-equity swap with sub-prime borrowers.

With a debt-for-equity swap, a troubled subprime borrower would give up 20 percent of the equity in his home in exchange for a 20 percent reduction in the outstanding balance on his loan. This would reduce his monthly payment of principal and interest by 20 percent.

The swap is in some ways a compromise between two other mortgage relief plans. Dean Baker would have homeowners give up all of their equity and become renters. Steven Pearlstein would have the size of mortgage loans reduced to what the borrower could presumably carry using standard income guidelines.

The Baker plan strips homebuyers of their asset in order to remove their mortgage liability. He thinks that homebuyers are victims of a bubble, and somebody else needs to bear the cost. The Pearlstein plan gives buyers a reduction in their liability in exchange for nothing. He thinks homebuyers are victims of aggressive lending, and somebody else needs to bear the cost.

The swap plan treats homebuyers as adults who made grownup decisions. It says that they can stay in their homes, but they have to give up some of their equity in order to do so. However, unlike the Baker plan, they do not have to revert to becoming renters.

How it would work

To implement the swap plan, government would create an agency to buy equity from troubled borrowers. Call this new agency Bailie Mae.

When a borrower swaps with Bailie Mae, the borrower's monthly payment of principal and interest immediately falls by 20 percent. Instead, Bailie Mae provides the other 20 percent of the monthly payment. The borrower still has to pay the full cost of other components of the mortgage payment, such as taxes and insurance.

As long as the borrower makes the new monthly payment, he stays in the home. When the home is sold, 20 percent of the gross proceeds go to Bailie Mae. At that time, Bailie Mae will be responsible for repaying 20 percent of the outstanding balance on the mortgage loan.

For example, suppose that the outstanding balance at the time of the swap is $100,000, and the borrower's monthly principal and interest is $800. With the swap, the borrower's monthly principal and interest payment would drop to $640, and Bailie Mae would pay $160 per month.

Several years later, the borrower gets a job in a new city and sells his home. By this time, the outstanding loan balance is, say, $90,000. Bailie Mae is responsible for 20 percent of that, or $18,000, with the borrower responsible for the remaining $72,000. If the home sells for $110,000, then 20 percent of that goes to Bailie Mae, which means $22,000. Another $72,000 is used by the borrower to pay off the loan, leaving $16,000 to go to the borrower.

Suppose that the house is sold for only $80,000. In that case, Bailie Mae gets only $16,000 even though it still has to pay $18,000. The borrower gets nothing, and $62,000 goes toward paying off the loan. The cost of the remaining $10,000 shortfall in paying back the loan is borne by the responsible lending party--perhaps a bank, perhaps a mortgage insurer, perhaps another financial market participant involved in trading credit derivatives. If there are large, widespread losses, they will be borne mostly by the original investors, and only somewhat by Bailie Mae.

Many economists are pessimistic about the outlook for home prices. If they are correct, then the swap plan will spread the losses around. Most of the losses will be borne by investors on the lending side. Some of it will be borne by homeowners. And some of it will be borne by Bailie Mae.

Other economists (well, Kevin Hassett and me) think that home prices are close to bottoming out. If we are right, then nobody has to take a big loss. Bailie Mae could fail to live up to its name and actually make a profit. In the meantime, it enables stretched homebuyers to make the monthly payments on their loans.

Unlike other plans, the swap plan forces borrowers and lenders to live with the terms of their original agreements. In the Baker plan, the homebuyer gets a "do-over" on his decision to buy rather than rent. In the Pearlstein plan, the homebuyer gets a "do-over" on the size and type of mortgage loan.

However, like the Pearlstein plan, the swap plan lowers the borrower's monthly payment. This makes it easier for borrowers to remain in their homes.

The swap plan gives the government, in the form of Bailie Mae, some risk exposure relative to housing market performance. If house prices climb rapidly enough, Bailie Mae makes a profit. If house prices are sluggish or fall, then Bailie Mae absorbs some losses, but homebuyers and lenders bear most of the cost. If there is a big decline in house prices, the largest risk remains with the lenders, which I believe is where it belongs.

The beauty of the swap plan is that it keeps government involvement proportionate to the size of the problem. Suppose that the crisis is real, meaning that house prices need to fall sharply in order to restore balance in the market. In that case, the swap plan will put some of the burden on taxpayers, while leaving most of the burden on investors. On the other hand, if the housing market is close to reasonable balance today, then the swap plan will cost little or nothing. It would ease my worry about enacting an expensive solution for a non-existent crisis.


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