Sub-Prime

Without a root and branch solution to the housing crisis, we must expect one expensive "bailout" program to follow another, with all failing to take hold due to the continued fragility of household and financial sector balance sheets. What makes this so tragic is that there are simple, inexpensive, fair, and efficient ways to end the crisis.

The key is to facilitate a program of renogotiation of under-water mortgages based on sharing of housing equity. The standard mortgage contract calls for the borrower to make a fixed stream of payments. Yet it is implicitly understood by both borrower and lender that such payments will not be possible in various states of the world. Rather than try to specify all such contingencies up front, both parties understand that the contract terms can be revisited in unusual contingencies and suitable adjustments made. In some such contingencies of non-payment, economic logic dictates enforcement of the original contract terms, in which non-payment of the full amount due leads to default and foreclosure. In others, it dictates renegotiation that may fundamentally change the terms of the contract. This is the situation in which we find ourselves today. It was not foreseen in the initial contracts that home values around the country would crash simultaneously with massive declines in income. Given that this negative outcome was largely out of the control of the individual homeowner, renegotiation is the necessary and obvious solution. If such a tragic change of circumstance befell a business, the creditors would quickly agree to swap debt for equity. That is what is needed today in the mortgage market.

If this is such an easy solution, why hasn't it happened? The answer lies in the political sphere. While disastrous choices in the financial sector led us into the crisis, it is policy makers who bear most of the blame for the lack of large scale renegotiation. They must immediately clear barriers to renegotiation, many of which derive from incoherent regulations. The following sources contain information on exactly what is needed in this regard. We are currently driving down a very dangerous road. If we do not turn around quickly, we risk having a really bad crash.

1. The executive summary of an article on "Mortgages and Households" that is featured in the NYU Stern School White Papers. The paper presents a five part plan of action to overcome barriers to renegotiation of existing mortgage contracts. The first stage involves regulators and legislators specifying terms of debt for equity swaps. The second involves their creating an appropriate fiscal and accounting framework. The third involves their setting up projects to demonstrate the economic viability of debt for equity swaps. The fourth involves addressing legal obstacles posed by securitization. The fifth involves the simplification of secondary default for borrowers who swap debt for equity.
Executive Summary

2. An editorial from the Wall St. Journal entitled "We Can Keep People in Their Homes", and subtitled "Let Lenders Profit Later for Easing Terms Now".
Opinion Column

3. A link to a presentation on reforming the housing finance market that was given at the Hamilton Project in Washington D.C. on September 12, 2008. Note that there is also a policy primer that explains the proposal in short order.
Audio of Session
Description of Paper and Primer
Paper
Policy Primer

4. A link to a paper specifying precisely how regulators could accomplish the changes that would enable the proposed reform to take place.
Regulatory Changes

5. A link to a presentation on the Leonard Lopate Show, the "Please Explain" segment, that provides a broader perspective on how the problems originated, and how intricate they have become.
Lopate Show

6. A link to a very short article on SSRC Website predicting that the policy measures being adopted will continue to use muscle rather than mind, and of the damaging long run consequences of viewing the crisis as the result of "too little" regulation, rather than incoherent regulation.
SSRC Comments