Another Problem with Martin Feldstein’s Mortgage Plan
Martin Feldstein proposes
a programme of “mortgage replacement loans” that I believe would stop the downward spiral of house prices. The basic idea is to provide an incentive to stop defaults among those who now have positive equity but are vulnerable to a further price decline. The federal government would offer every homeowner with a mortgage the opportunity to replace 20 per cent of that mortgage with a low interest government loan – up to a loan limit of $80,000 (€55,000, £44,000) – that reflects the government’s lower borrowing rate. Creditors would be required to accept this partial mortgage pay-down and to reduce the monthly interest and principal by the same 20 per cent. That mortgage replacement loan would not be collateralised by the house but would be a loan that the government could enforce by lodging a claim on an individual who does not pay.
Greg Mankiw thinks potentially distressed homeowners won’t go for it because this
"mortgage replacement loan" scheme involves tricking homeowners into accepting a deal that is not really in their self-interest. For very little in return, they give up the option of future default. So count me as skeptical.
There is another problem: non-distressed homeowners will go for it. The 30-year treasury rate is a little less that 4.5%. Someone with a 6.5%, $1,000,000 mortgage on a $2,000,000 home has little reason not to have the government refinance $200,000 of their mortgage because it would yield an interest savings of $4,000 per year.
Although making such a loan seems like a small risk (assuming that Feldstein means his loan would not be dischargeable in bankruptcy) the risk is not zero and that means there is a cost to the government of making a bunch of low interest loans to the non-needy.
If, as Feldstein and Mankiw agree, "there are no easy answers" why not let things play out as they are, but use this as an opportunity to try to get government out of the housing market by getting rid of Fannie Mae and Freddie Mac and making other changes along the same lines? There are pretty strong reasons to default to market solutions absent strong evidence that (i) there is a market failure and (ii) the government can fix that failure.