John Vogel is an adjunct professor at Dartmouth's Tuck School of Business.
Housing continues to be a major drag on the U.S. economy. Many factors prevent this problem from being solved, but a key obstacle has been arguments based on moral hazard. From the outset of this crisis, politicians and angry citizens have railed against rewarding the "bad behavior" of homeowners who took on mortgage debt that they could not afford.
More than three years into the housing crisis, with foreclosures and underwater mortgages casting a dark cloud over the housing market and the economy, it is time to chart a new course. The best place to begin is by recognizing that while homeowners made mistakes so did the lenders. Based on the assumption that houses would never go down in value, lenders made bad loans. In addition, the largely unregulated mortgage market allowed most players to earn their full fees for underwriting and selling loans regardless of how the loans performed.
Looking back over the last three years, millions of innocent people have been hurt by our "punish the home buyer" mentality. First we have the millions of children who have lost their homes or been under the constant threat of losing their home. Communities have suffered as neighborhoods deteriorate and the tax base erodes. And then there are the rest of us, who are victimized by the weak economy and high unemployment. What I cannot figure out is who has benefited as billions of dollars of housing wealth has been destroyed.
There is a potential solution that, I believe, is worth trying. While it will not solve all of the current housing problems, it could make a significant difference. Common sense and a number of academic studies show that the most effective way to deal with people who owe more than their house is worth is a permanent reduction in the mortgage principle. If my house is worth $200,000 and the mortgage is $300,000 it makes little financial sense to stretch each month to make the payment, especially when the alternative is to pay nothing for the next two or three years while the lender pursues foreclosure. While I am not advocating that people ignore their legal and moral obligation to pay their debts, three years of data clearly proves that in this situation a lot of people stop paying.
So what is the alternative? One potential solution is shared appreciation mortgages. Essentially, in exchange for a reduction in their mortgage principal, homeowners would give up some percentage (I recommend 50 percent) of the future appreciation on their house when it is sold. This is a complex instrument, but I believe it could be simplified and standardized. The loan reduction could be based on a simple appraisal and the lenders share of future appreciation would be 50 percent of the difference between the future sales price and the appraisal.
One advantage of this "shared appreciation" approach is that not everyone will want one. If your house is only slightly underwater or not underwater at all, most of us would not be willing to give up 50 percent of future appreciation. Similarly to be eligible, a homeowner would have to prove that with a lower mortgage and perhaps a lower interest rate, they have sufficient income to afford the new mortgage. Finally, this program would only be for a homeowner's primary residence and not for investors.
Shared appreciation mortgages are not new. Community development corporations have been using them successfully for years to ensure that affordable housing stays affordable. Institutional investors have also used this structure for years in financing commercial properties. Recently, Boston Community Capital has been using this technique as a foreclosure prevention mechanism, enabling families to avoid foreclosure. Lenders have found that working with Boston Community Capital, they receive more money than they would get through the foreclosure process.
For this program to work at a scale that will make a significant difference, we need to unleash the private market. To do that, the rules must be simple and clear so that mortgage brokers can quickly determine if a particular family is eligible for a shared appreciation mortgage. This program cannot be "voluntary to the lender," which has been the downfall of every foreclosure mitigation program over the last three years. Lenders have had enough time to deal with their bad loans. Rather than allowing them to continue to "delay and pray" we need to reset millions of mortgages and jump start the economy.
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