What America Needs is a Fixed 4% Mortgage

New York City - Debt crises, as I have written before, are as old as civilization. And history has shown that when debt exceeds the ability to repay, there is only one solution: debt reduction. This can take the form of a general release as in the Biblical jubilee or laws of Solon in ancient Athens, a moratorium on repayment and reduction of interest as in the decrees of the Roman emperor Tiberius, forgiveness of principle as in Bono's initiative for the developing world, bankruptcy at the level of the individual firm, or if all else fails, inflation as in Germany after World War I. However, there is no getting around the fact that when people can't pay, the only real answer is debt reduction. It is time for Congress and the Administration to face up to that fact in the arena of mortgages as we work through the current financial crisis.

Mortgages remain a key part of the current crisis, as evidenced by the vastly different fate of banks that currently hold mortgage-backed securities such as Citi (whose stock is trading at 3.7) and banks that avoided them such as JP Morgan Chase (whose stock is trading at 25).  The biggest casualties of the crisis so far -- such as Bear Stearns, Lehman and AIG, not to mention Fannie and Freddie -- fell, in large part, due to their involvement with mortgage- backed securities. Mortgage-backed securities and the mortgages that underlie them remain at the eye of the financial hurricane.

However, at the level of the individual household, the mortgages that underlie them are also hampering recovery. Forced to choose between keeping their homes and spending, people will try to keep their homes as long as possible. Unsustainable mortgage payments, thus, are a direct challenge to any effort to jump start the economy. Absent real action by the government, these mortgage payments will continue to drive foreclosures, lower home prices and eviscerate household budgets for the foreseeable future. Fortunately, there is something government can do.

While principle amounts as well as interest rates are a problem, the latter can be altered simply by allowing Americans to refinance into affordable fixed rate mortgages. Of course, banks themselves are not about to lend money to mortgage buyers at 4% in the current environment. That is why the federal government needs to step in with an ambitious new federally guaranteed mortgage to solve the mortgage crisis once and for all. 

A new low-interest mortgage is the key ingredient needed to get American households spending again. In other words, it is no exaggeration to say that economic recovery is hostage to mortgage reform.

Someone who has been writing about the need for debt reduction for some time is British historian Niall Ferguson who returns to the subject today in the Financial Times.  He notes that in the 19th century, it was common for governments to replace 5% notes with 3% notes through a process called conversion. When markets are working properly, it is often possible for borrowers themselves to practice conversion by refinancing at a lower rate. However, in today's environment in which underwater mortgages continue to cripple household budgets but replacement mortgages are hard to come by, Ferguson makes the point that conversion of the whole class of adjustable rate mortgages with a new low-interest mortgage is needed to work through the current crisis.

Not everyone would take advantage of the U.S. mortgage, as I would call it, nor should they.  If someone's house has depreciated well below the level of the mortgage, that mortgage is no longer worth par. Provision might be made to permit banks to sell underwater mortgages at a hefty discount. However, a large share of high-interest mortgages that are currently problematic for lenders and crippling for borrowers could be converted into stable-performing mortgages through an orderly refinancing into a 4% fixed-rate mortgage. A universal waiving of pre-payment penalties would be a small price to pay to fix a gigantic problem with one stroke. The program is doable today at rates south of 5% because of historically low costs to the government of borrowing. 

The benefits going forward would be immense. Ferguson argues that "permanently lower monthly payments for a majority of US households would almost certainly do more to stimulate consumer confidence than all the provisions of the stimulus package, including the tax cuts."  In my view, they would complement other efforts. And think of the long-term benefits after the current crisis subsides! A stable, low-cost mortgage for American families would improve family budgets, living standards and the U.S. economy for many years.

In short, America needs three things to stimulate the economy: the recovery package that is now approaching passage; a plan to revitalize the banking sector, which the Treasury Department should release soon; and finally, a 4% fixed-rate mortgage to address the housing crisis. Fixing the housing problem was mysteriously absent from the Bush efforts to address the crisis. Now that Obama economic team is in place, the Administration and Congress should work rapidly to develop this critical third piece of the economic recovery.