Eric Posner has a Slate piece offering a novel plan for “renegotiat[ing] all those bad loans at no cost to the taxpayer.”
The solution to this problem is for the government to force renegotiations to occur. A simple plan could do this. The plan would give all homeowners who live in a ZIP code where house prices have dropped more than 20 percent the option to have their mortgage reduced to the current market value of the house. In exchange, these homeowners would yield to their lenders 50 percent of the future appreciation of the house. To avoid any gaming and future moral hazard, both the current and the future value of the house will be determined by multiplying the purchase price and the variation in the housing price index. So if you bought your house for $300,000, and the average house in your ZIP code has lost 20 percent of its value, then your new house is assumed to have a value of $240,000. If your mortgage was $280,000, now it is $240,000 (the new value of the house). You are no longer underwater.
For the homeowner, this is a very attractive proposition. Suppose he has a $300,000 mortgage on a house he bought for $350,000 but today is worth only $200,000. With the plan, he will receive a $100,000 reduction in his mortgage in exchange for giving up a portion of the future appreciation of the house should that happen. Using the tools of finance theory, we can calculate the value of the “option” that the homeowner gives to the bank. Assuming an 8 percent annual volatility in house prices and an 11-year tenure in the house, the option is worth $36,000. The homeowner loses $36,000 from the lost future appreciation but gains $100,000 in the reduction in mortgage debt: a good deal. The homeowner also has a good incentive to maintain his property. If the homeowner adds a bathroom, he reaps the full benefits of this addition when he sells the house. Although he must pay the bank 50 percent of the increase in the price of the average house in the ZIP code, he keeps any additional return if his own house appreciates more quickly than the average house because of the new bathroom.
This does strike me as a better solution than the Obama Plan. It is hardly, however, without moral hazard.
What of those of us who put down a substantial down payment and so are not “under water”? Our houses have still depreciated in value but, because we were responsible, our outstanding loans are still secured. Meanwhile, our neighbors, who bought a house they couldn’t afford, are rewarded with a free $100,000 or $200,000 or whatever. In essence, our down payment would have been stolen from us by the government.
