NCPA - National Center for Policy Analysis


November 19, 2008

The more than 12 million homeowners with mortgage debt have an incentive to default because mortgages are generally "no-recourse" loans -- creditors can take the property if the individual defaults, but cannot take other assets or income to make up the difference between the unpaid loan balance and the lower value of the house.  As a result, mortgage default rates are now rising rapidly and are expected to go much higher, says Martin Feldstein, chairman of the Council of Economic Advisers under President Reagan.

The key to preventing further defaults and foreclosures is to shift mortgages into loans with full recourse.  But the offer of a low-interest-rate loan is not enough to induce a homeowner with substantial negative equity to forego the opportunity to default, says Feldstein.

Consider a homeowner with a $240,000 mortgage and a home worth $200,000:

  • The $40,000 gap between the mortgage and the appraised value could be divided with the government taking one-third, the creditor taking two-thirds and the homeowner agreeing that the $200,000 loan would have full recourse.
  • The creditor would give up about $27,000 of potentially uncollectible debt but would avoid the extra loss of value that comes with selling a foreclosed property.
  • The homeowner would get to keep his house and would eliminate all of the excess debt.

With 12 million negative-equity homes and an average negative equity gap of $40,000, the total cost to the taxpayers of taking one-third of the losses would be no more than $156 billion.

However, recent proposals are calling for creditors to reduce the monthly mortgage payment to a specified fraction of the homeowner's income by stretching out the repayment schedule of the mortgage or provide a temporary reduction in the interest rate on the mortgage.   Providing an incentive to shift the current negative-equity loans to full-recourse mortgages should be Barack Obama's highest priority as he seeks to stabilize the economy, says Feldstein.

Source: Martin Feldstein, "How to Help People Whose Home Values Are Underwater," Wall Street Journal, November 18, 2008.

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