The federal government would offer all homeowners with mortgages the opportunity to replace one-fifth of their existing mortgage (up to some dollar limit) with a government loan. This loan would carry a substantially lower interest rate than the individual's mortgage (reflecting the government's cost of funds). It would be a full-recourse loan that would have to be repaid regardless of what happens to the borrower's mortgage or home. By law, it would take priority over all non-mortgage debt.He then offers a hypothetical:
Consider how the program would work for someone who has a $360,000 mortgage on a home worth $400,000, a 90 percent loan-to-value ratio. A 15 percent drop in prices would push that homeowner into a negative equity position, because the house's value would be only $340,000. But if one-fifth of that $360,000 mortgage ($72,000) were converted to a loan from the government, the mortgage loan be $288,000. As a result, the 15 percent decline in housing prices would still leave the homeowner with $52,000 in positive equity -- the difference between the reduced house price of $340,000 and the new mortgage of $288,000. There would be a strong reason not to default.This proposal would only work if Feldstein's hypothetical homeowner represented the typical homeowner in danger of defaulting. But it's highly unlikely that's the case. Feldstein seems to think that because experts are predicting a further 15% decline in aggregate housing prices, the typical house has just 15% further to fall. When experts say that housing prices will fall another 15%, they're talking about a 15% decline in the Case-Shiller indices or the OFHEO indices. These home price indices measure aggregate housing values in given metropolitan areas—they don't measure median home prices. The Case-Shiller national composite index measures housing values in all the MSAs (which is then converted into an index number with the same base value as the MSA-level indices). Saying that housing prices will fall another 15% on the Case-Shiller national composite index doesn't mean that the price of a typical house will fall another 15%. Let's say a majority of houses in a given MSA don't decline in price at all, but a small minority of houses in the MSA experience dramatic price declines (on the order of, say, 50%), which leads to a 15% decline in the Case-Shiller index for that MSA. Allowing the homeowners who experienced 50% price declines to replace one-fifth of their mortgages won't stop them from going into a negative equity position (assuming normal LTV ratios), and thus won't reduce the number of defaults. I'm sure there are some homeowners who are in the same situation as Feldstein's hypothetical homeowner, and Feldstein's proposal would undoubtedly help them. But given the huge number of additional foreclosures predicted, it's hard not to find proposal wanting.