How a "Gap Lien" may fix the housing mess

I have listened over the past three months about all of the different solutions, fixes, schemes or inaction that have been proposed to solve the housing crisis. I think that I may have come up with something that can fix it.

First, let's be clear what the problem is. For the past several years we have had inflating housing prices, caused by a number of things previously discussed, and these houses have mortgages on them that the owners took out in order to purchase them. Some, if not most, of the mortgagees got mortgages based on their actual ability to repay the original loan amount. In other words, a conventional mortgage. However, as the prices were skyrocketing, lots of speculators and average citizens saw the ever expanding bubble as a way to make either a quick profit by flipping the house, or as a way to buy way more house than they could normally afford by entering into a risky mortgage with the hope of refinancing it in a few years, leveraging the increased equity created by the bubble.

Now, what we have is a perfect storm:
  • The bubble has burst.
  • Housing prices have fallen 20% on average so far, and the bottom is still ahead.
  • Mortgage holders owe much more than their home is worth
  • Those that took out risky loans are not only upside down, but could never afford the loan in the first place.
  • Those that were going to re-fi on the bubble equity are screwed.
  • People are beginning to lose their jobs, which impacts those responsible families that have conventional mortgages.
  • People that need to sell and move cannot get a price that allows them to pay off their mortgage and get out of their house.
Bottom line: mortgage holders, banks, and mortgage backed security holders have financial instruments that are worth far less than they are supposed to be worth. In a classic, pure-play capitalistic economic system, there should be LOTS of foreclosures, bank failures, and losses by investors and property owners. The government cannot let this happen for obvious reasons.

Have you ever noticed that the government (no matter which party) is always reticent to slow down rampant growth and profit taking, but always wants to back fill losses?

OK, so what is my great idea to fix this mess? The Federal Government, administered through the states, will create a fund that will pay for the gap between the price that was financed by the original mortgage and the price that the home is valued at when the new mortgage is taken out. The latter value should reflect the fair market value of the property at the time of the sale. This amount would then be applied to a lien against the property. This would be a special type of lien called a "Gap Lien" which would remain until it is paid down, but unlike most liens, it would not preclude any sale of the property because of its existence. It would only apply to your primary home of residence. There should be some sort of 'handling fee' to administer it which must be paid, not financed and a penalty could be taken against the lending institution for allowing it to happen in the first place. There could even be a nominal interest that would be accrued on the outstanding amount, payable upon redemption, so that taxpayers would at least make a little bit of money on the process. (Don't get greedy with penalties and interest like the IRS, just make it worth the trouble for the taxpayer.)

Here is how it would work: Let's say you bought a $410,000 home in 2005 and you put $10,000 down on it. You got one of those crazy interest-only loans from Countrywide with a four year bubble. Your monthly payment on a 30 year 6% loan would have been about $2400/mo (principal and interest), but you got a deal where you only paid $1500/mo, allowing the principal owed to stay at $400,000 and the difference in interest is tacked onto the loan. So now you owe something like $420,000. Now, the four years are up and Countrywide (now Bank of America) comes knocking at your door. Trouble is, your house is probably worth $300,000 now and you would have trouble selling it at that.

If it could be worked out, you would refinance your loan at $300,000 which would run about $1800/mo at the same terms as above. The government would pay the difference between the original amount $400,000 and the $300,000 which would be $100,000 minus a penalty (maybe 10%). This penalty would be absorbed by the original mortgagor. So, at closing, the new mortgagor would send $300,000 to the original mortgage holder and the Feds would send $90,000. The $20,000 that is owed above and beyond the original $400,000 would have to be eaten by Countrywide because of their stupid and predatory lending practices.

So, the 'homeowner' keeps his home, has a manageable (hopefully) $300,000 mortgage, the original mortgagor is made almost whole and the government holds a $90,000 lien against future sale of the property.

Let's imagine that in five years, the homeowner needs to move. His home is now worth $350,000 on the open market. When he sells his home, he gets to keep the equity from the principal pay-down after 5 years. In this case, it is about $21,000. The difference between the original $300,000 and the selling price of $350,000 would go to reducing the Gap Lien. So now the lien would be $40,000 and would convey to the next homeowner, and so on, until it is paid off.

This ploy is similar to the Home Owners' Loan Corporation, a Depression Era organization that was retired in 1951 after all of the guaranteed mortgages were paid off. The difference is that the HOLC actually made loans, the Gap Lien would be like a second mortgage until paid off.

The home crisis is the straw that broke the camel's back on our economy. Yes, there are a number of other problems traceable to Wall Street, but the home crisis is what started our precipitous decline and we won't start digging out of this hole until the housing problem is fixed. Is this plan perfect? No. Will people game the system? Of course, but if we can get a 90% success rate out of this program and prosecute the scofflaws that abuse the system, we can take a big step toward starting our next bubble.

As with any bubble, this one has burst.


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