There’s always something to howl about.

Instead of a bailout of troubled borrowers, why not implement an equity-sharing plan?

Via Poor and Stupid, TCS Daily has a free (or at least free-er) market solution to bailouts for struggling mortgage borrowers.

The idea? “[A] debt-for-equity swap with sub-prime borrowers.” Borrowers would give up 20% of their downstream equity in their homes in exchange for 20% debt and therefore payment relief:

To implement the swap plan, government would create an agency to buy equity from troubled borrowers. Call this new agency Bailie Mae.

When a borrower swaps with Bailie Mae, the borrower’s monthly payment of principal and interest immediately falls by 20 percent. Instead, Bailie Mae provides the other 20 percent of the monthly payment. The borrower still has to pay the full cost of other components of the mortgage payment, such as taxes and insurance.

As long as the borrower makes the new monthly payment, he stays in the home. When the home is sold, 20 percent of the gross proceeds go to Bailie Mae. At that time, Bailie Mae will be responsible for repaying 20 percent of the outstanding balance on the mortgage loan.

For example, suppose that the outstanding balance at the time of the swap is $100,000, and the borrower’s monthly principal and interest is $800. With the swap, the borrower’s monthly principal and interest payment would drop to $640, and Bailie Mae would pay $160 per month.

Several years later, the borrower gets a job in a new city and sells his home. By this time, the outstanding loan balance is, say, $90,000. Bailie Mae is responsible for 20 percent of that, or $18,000, with the borrower responsible for the remaining $72,000. If the home sells for $110,000, then 20 percent of that goes to Bailie Mae, which means $22,000. Another $72,000 is used by the borrower to pay off the loan, leaving $16,000 to go to the borrower.

Suppose that the house is sold for only $80,000. In that case, Bailie Mae gets only $16,000 even though it still has to pay $18,000. The borrower gets nothing, and $62,000 goes toward paying off the loan. The cost of the remaining $10,000 shortfall in paying back the loan is borne by the responsible lending party–perhaps a bank, perhaps a mortgage insurer, perhaps another financial market participant involved in trading credit derivatives. If there are large, widespread losses, they will be borne mostly by the original investors, and only somewhat by Bailie Mae.

Many economists are pessimistic about the outlook for home prices. If they are correct, then the swap plan will spread the losses around. Most of the losses will be borne by investors on the lending side. Some of it will be borne by homeowners. And some of it will be borne by Bailie Mae.

Other economists (well, Kevin Hassett and me) think that home prices are close to bottoming out. If we are right, then nobody has to take a big loss. Bailie Mae could fail to live up to its name and actually make a profit. In the meantime, it enables stretched homebuyers to make the monthly payments on their loans.

More:

The swap plan gives the government, in the form of Bailie Mae, some risk exposure relative to housing market performance. If house prices climb rapidly enough, Bailie Mae makes a profit. If house prices are sluggish or fall, then Bailie Mae absorbs some losses, but homebuyers and lenders bear most of the cost. If there is a big decline in house prices, the largest risk remains with the lenders, which I believe is where it belongs.

The beauty of the swap plan is that it keeps government involvement proportionate to the size of the problem. Suppose that the crisis is real, meaning that house prices need to fall sharply in order to restore balance in the market. In that case, the swap plan will put some of the burden on taxpayers, while leaving most of the burden on investors. On the other hand, if the housing market is close to reasonable balance today, then the swap plan will cost little or nothing. It would ease my worry about enacting an expensive solution for a non-existent crisis.

The best thing the government can do is nothing. Everything it does will prolong the problem. Even so, this is much closer to a hand up than a hand-out, so it’s more likely to result in responsible behavior over time.

Technorati Tags: ,