The scope of the problem in the American housing market is illustrated by the statistics that total negative equity is presently estimated at $750 billion, and about 15 million homes are “underwater.”1 One proposal gaining traction is the concept of a “free” principal reduction for underwater borrowers.
We argue that this and all other government and policy proposals to “fix the housing market” the last few years fail because they throw good money after bad in targeting only the most distressed and riskiest borrowers, many of whom previously acted recklessly and/or may not be able to stay in any home — or even pay a modest rent — without outright government subsidies.
Such borrowers are beyond rescue and efforts to “save” them are neither worthwhile nor truly aimed at helping the housing market or the lenders whose credit is essential for real estate finance.
We present a proposal which flips so-called conventional wisdom on its head. Under our proposal, homeowners making substantial prepayments of at least $50,000 would have their principal reduced by two dollars for each dollar of prepayment.
Our proposal targets the most responsible and financially savvy homeowners. These homeowners are also the likeliest to strategically default on their mortgages, not out of fiscal irresponsibility or immorality, but out of economic rationality and a desire (however perverse) to be treated equally and capitalize on disastrously misguided government policies incentivizing irresponsibility.
A strategy that rewards the borrowers most likely to be the bedrock of communities will discourage strategic defaults and depress the supply of homes. Meanwhile, the strategy helps the lending banks most necessary for the healthy functioning of a real estate market dependent on third party financing, thereby encouraging the extension of mortgage credit to meet demand.
The ultimate recovery of the housing market requires the true equilibrium between supply and demand. The anemic demand of the past few years strongly indicates a substantial decline in home prices from current levels is necessary to boost demand and, barring a sustained economic recovery that is unlikely in the current regulatory climate, may be the only way to accomplish equilibrium.
Read More… Fixing The Housing Market