A Good Proposal For Dealing With The Mortgage Problem

Megan McArdle on Obama's proposed bailout

So the plan:

1. Forces the bloated and undercapitalized mortgage agencies to take on more debt without regard to creditworthiness

2. Cleans up only the least toxic loans

3. Will cost some unknowably huge amount of money

This is from a supporter.

My lunatic proposal for the day: why not make it easier to move homeowners out of homes they can't afford? Set up a streamlined foreclosure proceeding where a current or mildly delinquent homeowner can simply give the house to the bank and walk away. Do this with two legal provisos:

1. No tax on the forgiven loan

2. No black mark on the credit record. The bank marks the loan as fully satisfied.

The homeowner gets a fresh start, and the bank gets the house without the huge administrative costs that are normally associated with foreclosure. Everyone loses something, but no one loses a crippling amount, and there is no net transfer between two parties who are both in financial trouble.

I left a comment, but now let me expand on it.

We have always had Deed in Lieu of Foreclosure, which does precisely that, gets the borrower out now with only one (or one additional) black mark. However, it is not mandatory that lenders accept the offer. To give them some small amount of credit, lenders in aggregate are becoming more willing to do so. More of them are getting intelligent enough to do so. I would also strongly suggest making Deed In Lieu of Foreclosure much less of a black mark than it is. Someone who loses their job and promptly realizes the situation and takes steps to deal with it that do not result in a creditor losing money they don't have to is a responsible borrower. Someone who makes the lender go through the whole rigamarole of foreclosure is in an entirely different category. And someone who hires a lawyer to spin it out for 18 to 24 months extra while the lender keeps losing money needs to be placed in a special hell for the rest of their lives.

No tax of debt forgiveness was something we had from October 2007 through the end of 2008. I thought it was a good idea initially, but lender and market experience leads me to believe I was mistaken. It was what opened the door to more massive (temporary) increases in the available housing supply, massively lowering price equilibrium until we work through that inventory. My area (San Diego) being on the bleeding edge of this whole mess, had pretty much worked through previously existing problems and the market was ripe for a recovery and some of the data seems to suggest that one had started - and then people who were struggling got their "GET OUT OF DEBT AND TAXES FREE" card.

Complete tax forgiveness didn't work, but that doesn't mean a partial measure might not be an appropriate solution. I believe that a lessened tax rate (say 25% of normally due tax) but not complete forgiveness would be a measure worth trying, but the complete forgiveness motivated a lot of people who could have and should have seen it through to bail out, creating more problems for everyone else. By leaving a portion of the penalty intact, it motivates those who can afford their payments, but simply don't want to, to keep going. As I said in Why You Should Not Walk Away From Upside-Down Real Estate, the market is going to come back, it is only a question of when. What we need to do is have an honest dialog about what is an appropriate share of the normal tax. The idea is we don't want people bailing out if they don't have to, and we especially don't want to encourage anything like buy and bail, or "Bail and Buy" bailing out of one upside-down property so they can turn around and promptly buy another one that isn't.

Apropos of that, the second idea, no black mark on credit record, is inappropriate as well, as it encourages both "Buy and Bail" and "Bail and Buy" type planning. Even if the credit report were completely unmarked, several questions on form 1003 (The federally mandated mortgage application form) will bring it to light on any future loan applications these folks may submit. Furthermore, this amounts to deceiving the system, and will set the stage for further problems on down the line.

If, however, all the people who lost their homes due to this get the standard treatment, that's a lot of folks and a lot of potential customers that lenders are going to make up their mind that they want a year or so down the line. Just because things are paranoid now doesn't mean it's going to last forever. Lenders will create appropriate programs and demarcations and grades of treating the issue, thereby dealing with the problem and bringing these people back into the market. The ones who lose their home but otherwise take care of their credit will be fine. They may pay a slightly higher rate (or need a bit higher down payment) than people who didn't have a short sale, foreclosure, or deed in lieu, but the lenders will decide they want them as borrowers nonetheless. It's as inevitable as gravity. The ones who don't take care of their credit otherwise will suffer appropriate penalties. And once the folks who get another mortgage loan make a couple more years of on-time mortgage payments, I'll bet they get treated just the same as someone who never had a problem, and that's as it should be.

People have been trying to deal with this like it's a little problem, that we can easily solve in one fell swoop and get past, and that nobody needs to suffer any pain except maybe the lenders. None of that is true. None of that is possible. This is a major problem, but the end can be in sight if the government will allow the markets to act in their own best interests. What we need is a rational plan that doesn't repeat the causes of the problem we're trying to recover from, that enables and motivates as many people as practical to work through their problems so that the problem is no larger than it needs to be, that doesn't make the problem worse, but nonetheless encourages dealing with the problem and getting past it.

Once we do all of that, it's just a matter of time until we're back to a more normal market. If the government uses the remaining money from TARP to help stabilize the credit markets and otherwise stops trying to "help", I think that the markets will get it through the heads of the participants what they need to do in order to get out of this. Everybody knows already what they would have to do to get through it on their own, but they're putting off the reckoning because they're hoping the government will step in and save them from the bad consequences of their own bad decisions. Well, a certain amount of that is necessary simply due to politics, but the money the government spends has other ill effects, and it doesn't come out of some hyperspatial vortex. The time for the government to step back and tell people to work through things on their own has definitely arrived.

Caveat Emptor