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October 14, 2008

Bailing out the Bailout: The Stanford Model for Mortgages

The current issue of Foreign Policy has a Luigi Zingales proposal for extending the current bailout to mortgage holders. The argument, of course, is that further waves of defaults just keep us standing still. The contrary argument is that no-one forced anyone to buy these over-priced homes, so why help them. Feel free to argue either side, or both.

Congress should pass a law that makes a recontracting option available to all homeowners living in a ZIP code where house prices dropped by more than 20 percent since the time they bought their property. Why? Because there is no reason to give a break to inhabitants of Charlotte, North Carolina, where house prices have risen 4 percent in the last two years.

How do we implement this? We have reliable measures of house price changes at the ZIP code level, thanks to two brilliant economists, Chip Case and Robert Shiller. By using the Case-Shiller real estate index, the recontracting option will reduce the face value of a mortgage (and the corresponding interest payments) by the same percentage by which house prices have declined since the homeowner bought (or refinanced) his property—exactly like in my hypothetical example above.

In exchange, however, the mortgage holder gets some of the equity value of the house at the time it is sold. Here’s how it works: At the time of sale, the owner pays 50 percent of the difference between the selling price and the new value of the mortgage back to the mortgage holder. Stanford University successfully implemented a similar arrangement for its faculty, financing part of the house purchase in exchange for a fraction of the appreciation value at the time of sale.

The reason for this sharing of the benefits is twofold. First, it makes the renegotiation less appealing to homeowners, making it unattractive to those who don’t need it. For example, homeowners with a very large equity in their house (who do not need any restructuring because they are not at risk of default) will find it very costly to use this option because they will have to give up half the value of their equity. Second, it reduces the cost of renegotiation for the lending institutions, which minimizes the problems in the financial system.

The great benefit of this program is that it provides relief to distressed homeowners at no cost to the federal government and at the minimum possible cost for the mortgage holders. It will stop defaults on mortgages, eliminating the flood of houses on the market and thus reducing the downside pressure on real estate prices. By stabilizing the real estate market, this plan can help prevent further deterioration of financial institutions’ balance sheets.

More here.

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