Amidst all the discussion about bailing out the financial institutions, there has been little attention paid to addressing the fundamental issue behind the crisis, what Glenn Hubbard calls "the elephant in the room" - declining home values! Now, Daniel Alpert of Westwood Capital has come up with a Freedom Recovery Plan (FRP) to exchange interest between homeowners and mortgage lenders, without creating moral hazard.
The declining home prices have left homeowners holding a pile of debt which is higher than the value of the collateral it supports. Since mortgage loans are unsecured loans with liability limited to the housing collateral, in the aforementioned circumstances the mortgage holders are better off by just walking away leaving their homes and renting home elsewhere. Such foreclosures will in turn generate a downward pressure on home prices and exacerbate the downward spiral in the housing market.
Home values become all the more important given the fact that the success or otherwise of the financial institutions bailout plans depends on stemming the declines in home prices and stabilizing these values so that the recoveries from the bailouts investments are maximized. If home prices continue to decline and foreclosures mount, the values of the underlying mortgage backed securities will fall even more, thereby further squeezing the asset base of these institutions. The result of all this could be a deleveraging spiral cum liquidity trap and more bank failures, and a case of good money thrown after increasingly worthless and bad assets!
The settlements under the FRP would involve homeowner/borrowers, with impaired mortgage loans (mortgages exceeding home values), voluntarily surrendering the deeds to their homes to their mortgagees in consideration of the right of continued occupancy, as tenants, for a period of five years. After five years, the homeowner-turned-renter would have the right to buy the home back, at fair market value, from the lender.
The FRP minimizes the moral hazard by making the homeowner losing his equity on his house, albeit temporarily, and the lender taking a loss by way of reduced rents (which would be only 60-70% of the mortgage payments). Five years may be an adequate enough time to stabilize the housing and also the financial markets. The FRP does not involve any tax payer bailout and also seeks to give all existing homeowners a chance to get back into the ownership of their homes when they’ve gotten their financial houses in order. More analysis of the FRP is available here.
Update 1
Luigi Zingales has another plan.
Update 2
Jim Grosfeld has another plan which seeks to provide interest subsidy so as to reduce the interest burden on the most distressed mortgages.
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