How to Fix the U.S. Mortgage Market

Recent estimates suggest as many as 23% of US mortgages are “underwater” –the value of the home collateralising the mortgage has fallen below the loan’s balance. This column outlines a proposal to remove the threat of strategic default in these cases – one that it argues is not only fair but also the most likely to allow the US housing market to recover.

The current pool of US mortgages is suffering from two serious problems that continue to delay a recovery in housing markets and in turn threaten the broader economy. First, estimates put as many as 23% of US mortgages “underwater”, meaning that the value of the home collateralising the mortgage has fallen below the loan’s balance ( 2010). In most cases this was the result of ill-informed households purchasing homes at the peak of a housing bubble while reckless lenders allowed them to over-leverage. Thus there is widespread worry about strategic default. Second, the deep recession and slow current job growth continue to generate additional mortgage delinquencies (and subsequent defaults) as households remain unemployed. This proposal is specifically designed to solve the first problem although it could help the second as well.

To fix the underwater loan problem, existing mortgages could be restructured into two parts: a) a standard new mortgage against the current (reduced) value of the home, and then b) a claim against some fraction of any capital gains (above that reduced value) when the home is sold. The two parts could even be packaged separately and securitised or traded in separate markets. When a household sells their home they would then have to pay off both claims and take away their share of whatever gains accrued. Most likely the lender’s claim on future gains would be capped – for example at a value equal to the difference between the original mortgage balance and that created in part a).

For illustration, consider the dilemma of an owner whose original house and loan were established at $100,000, but whose house is currently worth only $60,000. The loan is thus 40% underwater. When restructured, the loan would be divided into a $60,000 traditional mortgage and a claim of, for example, 50% of the future appreciation – capped at $40,000. The borrower’s payments would fall by 40% but later when they moved and the property sold for, say $90,000, they would surrender $15,000 of the sales proceeds. The lender might even recover all its money if farther into the future the property sold for $140,000. The owner’s gain in this case would be reduced from $80,000 to $40,000. Since the claim is in “current” dollars, inflation alone holds out the prospect for eventual loan recovery.

For borrowers, this proposal would seem to eliminate the growing potential of strategic defaults, wherein owners walk from their underwater loans – suffering bankruptcy and the loss of future credit (Butta et al. 2010). The new loan’s payments would be more or less in line with what current buyers (of similar homes) are experiencing. Owners also would maintain a sizeable stake in the value of their property that aligns maintenance incentives. A worry over whether borrowers might immediately sell their homes to discharge their second claim obligation seems misplaced. Doing so would leave them with no equity, and hence (in today’s market) the inability to buy another house. Surely the combination of reduced payments and some future stake would entice most to resume their lives and move whenever true need and opportunity required it.

On the lenders’ side we know there is considerable resistance to restructuring mortgages – since restructured loans sometimes re-default while loans left alone often “self-cure” (Adelino and Gerardi 2009). The proposed restructuring actually makes “self-curing” more likely and re-default less likely. With the contingent claim, lenders also are able to add an additional (fully liquid) asset to their books relative to a conventional modification. The value of this contingent claim would vary by market. Those areas with more modest “bubbles” and subsequent price declines are quite likely to experience full price recovery. Markets that went truly overboard will take much longer – hence a lower value for a claim there.

Could the proposal help owners who are not able to make payments – even though their mortgage is still above water? Existing borrowers would surely accept a lower share of the upside in exchange for reduced payments (and balance). To induce lenders into this arrangement, the costs of foreclosure plus the value of the contingent claim would have to equal or exceed the write down in balance that each particular owner could afford. The proposed restructuring would not work for everyone but it might help some.

Interestingly, there are two historic precedents for similar forms of debt restructuring. In the early 1980s the Department of Housing and Urban Development suggested “shared appreciation” mortgages as a way of lowering payments for first time buyers. Pools of these bonds may have been issued, but an evaluation of them has been hard to find. Later, in 1990 the US and International Agencies together created “Brady Bonds” as a way of restructuring defaulted Latin American sovereign debt. Some of these bonds carried a provision in which debtor and lender both shared in bond appreciation.

In the current environment there is ample opportunity for the US government to lead in such mortgage restructuring. Trouble loans on the books of the Federal Housing Administration (and the government-sponsored enterprises) could be so repackaged and possibly a secondary market created for the contingent claims. The private sector would hopefully soon follow. Asset bubbles and excessive credit inevitably create the need for painful adjustment.

This proposal spreads the adjustment over time and splits it between lender and borrower. This seems not only “fair”, but also the most likely to allow the US housing market to recover.


•Adelino, Manuel and Kristopher Gerardi (2009), “Why Don’t Lenders Renegotiate More Home Mortgages? Redefaults, Self-Cures, and Securitization,” FRB Boston Public Policy Discussion Paper 09-4.
•Butta, Neil, Jed Kolkp, and Hui Shan (2010), “The Depth of Negative Equity and Default Decisions”, Federal Reserve, FEDS #2010-35, May.
• (2010), Press release of August 26.

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About William C. Wheaton 2 Articles

Affiliation: MIT

William Wheaton is a Professor holding a joint appointment in the Departments of Economics and Urban Studies and Planning. An authority on regional economics, Bill is a principal in a consulting firm that provides market analyses for development companies active in the market for commercial space.

A member of the MIT faculty since 1972, Professor Wheaton helped to develop the field of urban economics by pioneering the theory of how land, location, and housing markets jointly operate. He also specializes in the problems of urban infrastructure and local government finance. He has written numerous articles in scholarly journals throughout the world, and is a co-author of Urban Economics and Real Estate Markets, the first text book to cover both real estate applications and economics.

In the last few years, Professor Wheaton has been actively applying economic research to the real estate industry. He helped organize the MIT Center for Real Estate, and teaches the program's core course in Real Estate Economics. He was the first economist to apply econometric methods to the forecasting of real estate markets, and is a principal in Torto Wheaton Research, a globally-recognized real estate consulting firm that works with the real estate industry to better understand the fluctuations and trends of the market.

Professor Wheaton received a B.A. in Economics from Princeton University, and a Ph.D. from the University of Pennsylvania. Over the years he has worked with many US governmental agencies, as well as the World Bank and the United Nations. Closer to home, he has been a member of the planning commissions in each of the several towns where he has lived.

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