American homeowners continue to struggle under the weight of housing debt. Each quarter brings 300,000 new foreclosures and $100 billion in newly delinquent mortgage debt. More than 11 million homeowners are saddled with an underwater mortgage, for which the principal owed exceeds the value of the home.
The Obama administration has promised to take bold steps to help distressed homeowners. The administration would do well to modify a play from the private sector playbook. Companies like Ocwen have refinanced underwater mortgages by writing off debt in exchange for a share of the equity if the price of the home rebounds.
Such shared appreciation mortgages have not become widespread. The law limits banks from owning equity in homes, and it is more profitable for financial companies to wait for borrowers to default so they can buy properties cheaply at foreclosure.
The federal government should step into this breach and offer underwater borrowers a limited life, shared appreciation mortgage. Here is how such a plan could work if administered by the Federal Housing Finance Agency.
Suppose a borrower I will call Annie Mae receives a principal reduction on her loan so that her new loan balance is $100,000. When Annie sells the house, the FHFA would receive a fraction of the sales price -- for example, 20 percent -- in excess of $100,000. If Annie receives the benefit of a write-down, she has to give up a percentage of her profit when she sells her home. In this way, Annie sells some of the future equity in her home to help her through hard times.
What if Annie never sells her home? The prospect of the FHFA holding a long-term equity interest in American homes is politically unappealing. There is a conflict of interest when the government attempts to regulate an industry or sector in which it has a direct financial interest.
To address this, the FHFA should be required to unwind its equity position at the end of a fixed period of time, for example, five years.
Let's revisit Annie at the end of this five-year period. Suppose that the difference between the appraised value of her home and the amount she owes on her mortgage is $50,000. This is Annie's equity. If she sold her home at the appraised value, the FHFA would receive $10,000.
If Annie doesn't sell her home, then she should be obliged to take out a $10,000 home equity loan to pay off the FHFA. The FHFA should assist in structuring this loan so that its terms are no worse than her current mortgage.
Critics of principal reduction understandably fear taxpayer losses. But giving the FHFA equity in homes that receive a principal write-down should ease many of the doubts about this policy.
By increasing the program's revenue it would lower the cost of mortgage modification to taxpayers.
A shared appreciation mortgage will also discourage homeowners who can make their mortgage payments from applying for a principal write-down. These homeowners will be reluctant to give up their future equity gains for a current reduction in principal.
Four years into the housing crisis, millions of homeowners remain weighed down by loans based on inflated housing prices. With a little creativity and political resolve, the administration can both exercise fiscal responsibility and provide homeowners substantial relief.
Prasad Krishnamurthy is assistant professor of law at UC Berkeley's Center for Law, Business and the Economy.