Martin Feldstein, a Well-Respected Economist, has a Crackpot Idea

Economist's View points us to a Washington Post article by Harvard economist Martin Feldstein:

Home prices are down 20 percent from their peak in 2006 and are falling rapidly across the country. Experts predict an additional 15 percent decline during the coming year as the housing price bubble is undone.

The danger is that home prices could spiral further down, hurting millions of homeowners and pushing the economy into a deep recession....

I believe the federal government should create a firewall to prevent too great a fall in housing prices. It is important to go beyond the legislation that is about to be enacted by the Senate, which would help some homeowners who have negative equity but would not do anything to forestall the growth of this problem. This can best be done through a program of mortgage replacement loans.

Such a program might be structured this way: 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.

Such a mortgage replacement loan would eliminate the potential incentive to default for almost all homeowners who now have positive equity. In doing so, it would limit the number of foreclosures that could contribute to a downward spiral.

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.

A program of mortgage replacement loans would act as a circuit breaker to reduce the number of defaults that would otherwise occur as the housing bubble inevitably deflates. In doing so, it would stop prices from overshooting on the way down in the same way they did on the way up.

Feldstein is nuts. He claims to be worried about "overshooting" on the way down. History shows that declining home prices don't overshoot the way stocks often do. Instead, the decline slows as prices approach fair value. Then nominal prices stop falling as inflation gradually eats away at the real value of real estate. Nominal prices start rising again only when they have roughly reached fair value. The reason real estate prices don't overshoot on the way down is because they are sticky downwards.

Feldstein's concern about overshooting suggests that he thinks the fair value for real estate is a lot higher than it actually is. Notice that he thinks a 15% decline over the coming year would be enough to return housing to reasonable levels. (He's using real numbers, not nominal. With our current 4% inflation rate, he's talking an 11% nominal decline over the next year.) Feldstein's real aim is to prevent a much-needed real estate correction.

Feldstein is a Republican. I thought Republicans were supposed to believe in the free market. I guess they do except for when they don't.