My Plan to Address the National Mortgage Crisis

I have established this blog in order to more effectively broadcast a plan I developed last summer to address the national mortgage crisis and to spur further discussion to find additional solutions to the problem.

Recent Developments:
Over the past several months, people have finally begun to talk about adjusting the principal balances of failing or threatened loans. At the same time, though, they have identified some problems associated with such an approach, which they label "moral hazard" problems. The concept is that some people (typically borrowers) will get a free ride, to some extent, by being let partly off the hook for money they borrowed and agreed to repay.

The plan that I developed avoids these moral hazard problems because it does not simply advocate writing off part of the principal balance of the loan. Rather, the approach I have devised would treat the reduction in loan principal as an investment by the bank, which must later be repaid by the borrower when the house is sold. In this way, both parties will share the risk and the benefit of the loan; both have incentives to participate in such a program; and the program can prevent foreclosures, thereby slowing the decline of housing values in markets around the country.

Plan Overview:
Most of the loans that have gone bad consist of some kind of adjustable-rate mortgage (ARM), or similar loan structure that had an introductory period during which mortgage payments were artificially low. Once those introductory periods ended, borrowers' monthly payments increased significantly, often more than 15% or 20%. Because many borrowers had reached simply to make the payments during the introductory period, they could not afford to make payments once the terms of their loans reset.

The premise on which my plan is based is that, if borrowers could afford to make the monthly mortgage payments during the introductory period of the loans, then they could probably continue to make payments at that same level. The borrowers could then avoid foreclosure, remain in their homes, and continue to build up equity in the property with each payment. At the very least, this would help to stabilize housing markets and slow the decline of property values.

My plan describes how to calculate the extent by which to reduce the principal balance of a loan in order to return payments to their introductory levels. It further describes how to calculate the future compensation for the lender who agrees to reduce the principal balance. Finally, it describes how and when that compensation should be recouped by the lender.

This plan can be applied to any loan, whether already in default or soon to be in default, whether the loan is securitized or unsecuritized. The application of the plan to securitized loans would require participation by either a government agency, or by Fannie Mae or Freddie Mac (the government-sponsored entities, or GSE's), but would be a perfect application for TARP funds.

The details of the plan are described in a short (7-page) white paper that I have attached to this post. For those who wish to skip the detailed algebra, I have also attached a 6-page version of the white paper that includes only the illustrative formulas.

-Marc Gilmore