Short-term loan modifications, instigated by the federal government to help ease falling property values, are too insubstantial to reach the pith of the housing crisis: negative equity. As property values continue a trend to sink further underwater, even homeowners who can afford their monthly mortgage payments are becoming motivated to walk away as their chances of attaining a positive equity stake in their property during the next 10 to 15 years diminish. Approximately 26% of mortgage defaults are intentional, perpetrated by homeowners who owe significantly more than their property is worth. There is a solution to this seemingly impassable negative equity quandary: debt forgiveness in the form of a loan cramdown.

Multiple debt-forgiveness programs have been formulated. The concept proposed by the Milken Institute in Santa Monica calls for the government to refinance an underwater loan with two new loans. The first loan, in an amount equal to the current market value of the property, would be provided by Fannie Mae. The second loan, the amount the original loan exceeds the market value, would be interest only and issued by the United States Treasury. For each year the homeowner avoids delinquent payments on either loan, 1/5 of the Treasury loan would be forgiven. The cost of this program is estimated to be between $75 billion and $100 billion and is intended to save 1.5 million homes from foreclosure, intentional or otherwise.

A variation on the debt-forgiveness theme has been voiced by Ken Rosen, the chairman of the Fisher Center for Real Estate and Urban Economics at UC Berkeley. Rosen promulgates a debt-for-equity swap that gives the lender an equity stake in the property encumbered by the troubled loan in exchange for reducing the outstanding principal balance, trimming off some of the debt to be paid by the homeowner and affording the lender the opportunity to share in any value the property acquires through future appreciation.

first tuesday take:
As foreclosure woes continue to pummel the country (and more specifically, California) it is clear a debt forgiveness program in the form of a loan cramdown is desperately needed. Current loan modification and refinance programs address the symptoms; they don’t cure the negative equity disease. Even if the monthly payments are reduced, a homeowner still has no rational incentive to keep paying on a loan when he has no foreseeable chance of ascending from the negative equity pit.  Congress could cure the problem by allowing federal judges to reduce the loan to the property value or below. That would really give the lenders an incentive to hold short sales in great numbers or voluntarily outrun the courts by producing their own cramdown management programs.

Re: “Is it time for underwater homeowners to be given a get-out-of-debt-free card?” from the Los Angeles Times.