Renogiating Mortages

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.

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James Joyner
About James Joyner
James Joyner is Professor and Department Head of Security Studies at Marine Corps University's Command and Staff College. He's a former Army officer and Desert Storm veteran. Views expressed here are his own. Follow James on Twitter @DrJJoyner.


  1. Alex Knapp says:

    Just as a devil’s advocate argument though, what happens to the value of the house you own when you’re alone on your block in a sea of foreclosed properties?

  2. Billy says:

    I don’t see why a lender who is forced to reduce loan amounts shouldn’t get 100% of any appreciation, up to the full amount of the original loan. This still allows underwater borrowers to get out of depreciated homes with a windfall in any amounts they don’t have to pay back, but assuming housing prices eventually rebound, this means that nobody really gets a free ride.

    I can only assume the IRS would be taxing the loan forgiveness as income as well… I’d like to see the look on people’s faces when they realize they were just imputed $50,000.00 in income because the government bailed them out.

  3. Billy,

    I think the idea of splitting the appreciation is to give both sides an incentive in the property. The bank won’t maintain the house, the home owner will. So you want to keep the home owner happy.

    The more general problem I have is, unless you are planning on selling, who cares if you are underwater on your house. I buy a house to live in. If I am underwater and can continue to make the payments, ok. Not great, but ok.

    The issue is the 8% who can’t/aren’t paying their mortgage. If you have this deal, what percentage would then be able to pay their mortgage?

  4. JKB says:

    None of these plans are going to keep the false house prices up. The false prices were set by a whole lot of incapable buyers purchasing at prices they had no hope of being able to pay at the terms of the contract. Therefore, the prices are not set at the level that would be paid by a capable buyer of the asset.

    Trying to keep the incapable buyers or the deadbeats (those with the means to pay but choose to walk away) is a losing proposition. They never were buyers in the the normal sense but rather speculators who are simply looking for a way to cut their losses or regain their expected profits. Better to take the immediate price declines of foreclosure to get the properties in the hands of capable, responsible buyers.

    In the end, regardless of the bailout foolishness, the false prices will be subsumed by inflation giving property owners the psychological cover that they are ahead when real values will actually be underwater.

  5. Joe says:

    I don’t think there are going to be any solutions to this problem that will satisfy everyone involved. There were too many people being irresponsible and I doubt that there is anything that can be done to “fix” that problem.

  6. HiItsNino says:

    This is a good idea, but I read an article about 5 years ago that was warning of the coming doom and the guy said something about an insurance policy that would cost about $5 at the closing table and it would insure you would never owe more than your home is worth if you sold it. I liked that idea too, but this one is more relevant after the fact….

  7. Michael says:

    What of those of us who put down a substantial down payment and so are not “under water”?

    The problem is, that those of you were were responsible are not part of the problem, so helping you doesn’t help the problem.

  8. John425 says:

    Umm… In the above example–where is the money to add a bathroom coming from?

  9. Danny Glover says:

    We made a substantial downpayment (21 percent) and would have purchased another 5.3 percent in equity over the next four-plus years had the housing market not tanked, and we’re still underwater. That’s how much housing prices have declined in our area — way more than the 20 percent of this plan.

    I get tired of most discussions about the housing crisis assuming that EVERY borrower in a pinch these days is by definition irresponsible. Responsible homeowners/borrowers have been hurt by this economy, too. And both the irresponsible borrowers and the irresponsible banks who lent them money are to blame.

  10. Michael says:

    I get tired of most discussions about the housing crisis assuming that EVERY borrower in a pinch these days is by definition irresponsible.

    Are you in a pinch? If you can still make your mortgage payments, you’re not irresponsible, and therefore not part of the problem. In fact, your situation actually helps, because you can’t add your house on an already over saturated market at a low price.

    As yetanotherjohn stated, unless you plan on selling your house, it doesn’t matter to you if you’re underwater or not.