Feldstein Advocates Massive Mortgage Relief

Harvard economist urges $350-billion program to counter recession.

Writing in the New York Times, Baker professor of economics Martin S. Feldstein is urging a $350-billion program to reduce mortgage debt as a way to stem the wave of home foreclosures and reduce the risk of a double-dip recession. Feldstein is a pillar of American economics—president emeritus of the National Bureau of Economic Research, chairman of President Ronald Reagan’s Council of Economic Advisers, and a past president of the American Economic Association—and anything but a fiscal liberal, so his forceful advocacy of an unpalatable mortgage-relief program may carry unusual weight.

In his October 13 op-ed essay, “How to Stop the Drop in Home Values,” Feldstein acknowledges the obvious objection to permanent reductions in homeowners’ mortgage debt: “Voters don’t want their tax dollars used to help some homeowners who could afford to pay their mortgages but choose not to because they can default instead, and simply walk away. And voters don’t want to provide any more help to the banks that made loans that have gone sour.” The former objection is a moral one: it is unfair to those who paid their mortgages to subsidize those who have not (for whatever reason). The latter objection is political: banks were made whole by the TARP program, and don’t need more help. (An offsetting argument is that irresponsible lenders were bailed out, while their customers have been held responsible for the last cent of unfair loans.)

But Feldstein focuses on the practical problem. American homeowners’ net worth has been reduced $9 trillion since 2006, when the housing market peaked—$1 trillion of that in the last fiscal year. That depresses consumer spending, and prolongs and deepens the recession. House prices continue to fall because of defaults. Nearly 15 million homeowners owe more on their mortgages than their houses are now worth, he writes. So long as that is the case and jobs are scarce, the incentive to default is huge, particularly because lenders then end up with a house (worth far less than the nominal loan), and nothing else. Repeated endlessly, this is a formula for devaluation and recession as far as the eye can see. Even those homeowners who pay their mortgage debt but cannot sell their properties cannot move to a new job—part of the U.S. economy’s traditional adaptiveness—nor can those who have “underwater” loans tap home equity to start businesses or make investments.

Feldstein proposes a grand swap:

To halt the fall in house prices, the government should reduce mortgage principal when it exceeds 110 percent of the home value. About 11 million of the nearly 15 million homes that are “underwater” are in this category. If everyone eligible participated, the one-time cost would be under $350 billion.

That would be painful for lenders—banks and the federal housing lenders would have to recognize huge losses they have deferred (but will ultimately recognize if they take possession through foreclosure and have to sell the houses at depressed values). But to make the bargain fairer, Feldstein proposes a clever mechanism:

If the bank or other mortgage holder agrees, the value of the mortgage would be reduced to 110 percent of the home value, with the government absorbing half of the cost of the reduction and the bank absorbing the other half….And in exchange for this reduction in principal, the borrower would have to accept that the new mortgage had full recourse — in other words, the government could go after the borrower’s other assets if he defaulted on the home. This would all be voluntary.

In other words, lenders and borrowers both sacrifice—but maybe recession is averted and the country moves closer to a real economic recovery. As Feldstein concludes,

I cannot agree with those who say we should just let house prices continue to fall until they stop by themselves. Although some forest fires are allowed to burn out naturally, no one lets those fires continue to burn when they threaten residential neighborhoods. The fall in house prices is not just a decline in wealth but a decline that depresses consumer spending, making the economy weaker and the loss of jobs much greater. We all have a stake in preventing that.

Whether there is an audience for Feldstein’s prescription in today’s highly polarized political environment is uncertain. But the idea, and its source, are intriguing.

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