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WELLER: How to deal with failing financial institutions

COMMENTARY:

Policymakers at the Federal Reserve and in the Bush administration were slow to admit they had a mortgage mess on their hands. Foreclosure rates are shattering previous records, just to be broken a few months later. The Mortgage Bankers Association reports that the share of mortgages that entered foreclosure in the second quarter of 2008 stood at 1.1 percent, and the share of all mortgages in foreclosure was 2.8 percent during the same period. Since the 1970s, the share of mortgages entering foreclosure never exceeded 0.5 percent before the end of 2006, and the share of total mortgages in foreclosure never exceeded 1.5 percent before the second half of 2007.

The solutions have been tepid and so far not particularly successful in stemming the tide in foreclosures, as the string of continuing failures, such as Bear Stearns, Lehman Brothers and AIG, vividly illustrates. The track record of interest-rate cuts and voluntary industry-based mortgage work-out efforts does not inspire confidence.

Instead, policymakers need to address more forcefully the record level of foreclosures by helping struggling homeowners. The alternative is a massive bailout of the U.S. banking system, which as recent events suggest, we may be nearer to needing than should be considered comfortable.

One step would be to expand the ability of communities to purchase foreclosed properties. This is an idea that my colleague at the Center for American Progress, David Abromowitz, developed as the Great American Dream Neighborhood Stabilization program. Rather than have properties sit vacant and attract blight, local governments and their nonprofit partners will leverage funds provided for the bulk purchase of these properties, rehabilitate them as needed, and offer them for sale or rent at affordable prices. The rehabilitation process, in addition to returning these homes to productive use, will create construction jobs in an otherwise moribund sector of the economy. He advocated allocating up to $20 billion for these purposes, while Congress only allocated $3.92 billion in the last housing bill to adopt the program. Much more needs to be done, and done quickly.

Another option is to provide direct financial support to homeowners, especially lower-income ones. A number of observers have noted that the current practice of making the mortgage interest tax deductible disproportionately benefits higher income earners. Members of President Bush's 2005 Advisory Panel on Federal Tax Reform, for instance, proposed replacing the mortgage interest rate deduction with a 15 percent tax credit, which would have allowed all homeowners with a mortgage to receive a tax break instead of just those who itemize. As panel member and MIT professor James Poterba noted at the time, the top 2.2 percent of tax returns claim 22 percent of the benefits from the mortgage-interest deduction, whereas a tax credit would give all homeowners a tax break. And, Alice Rivlin, former vice chair of the Board of Governors of the Federal Reserve System and current senior fellow at the Brookings Institution, noted during a Nightly Business Report interview earlier this year that, "as we repair the damage from the bursting housing bubble, we need to focus on how to prevent the next one" and that "part of the answer should be converting the mortgage interest deduction to a credit." During this busy campaign season, Sen. Barack Obama, Illinois Democrat, has proposed his own version - a refundable "Universal Mortgage Credit" of up to 10 percent of mortgage interest.

Another possibility is to streamline the work-out solutions for troubled mortgages. A workable model is now emerging from the experience of the Federal Deposit Insurance Corp.'s receivership of the failed IndyMac Bank. This streamlined process should be applied to mortgages held by Fannie Mae and Freddie Mac in their own portfolio and in the mortgage-backed securities they hold on their books, as my colleague Andrew Jakabovics at the Center for American Progress has proposed. In addition to helping affected borrowers by lowering their payments and potentially restoring greater liquidity and certainty to the capital markets, the collective actions of the FDIC, Fannie Mae and Freddie Mac would serve as the de facto industry standard for handling defaulted mortgages, thus encouraging private servicers to act likewise.

And finally, the bankruptcy code could be changed to allow bankruptcy judges to write down the part of a mortgage of a principal residence that is no longer secured by property because its value has gone down. This option already exists for vacation homes and second homes, but not for people's first homes. It has been advocated by a number of consumer advocates, including the Center for Responsible Lending, which targeted its proposal toward families who otherwise would lose their homes.

Families are clearly still hurting in the wake of the mortgage market mess. Whether policymakers will rise to the challenge before even more Americans are affected remains to be seen.

• Christian E. Weller is an associate professor in the Department of Public Policy and Public Affairs at the University of Massachusetts at Boston, and a senior fellow at the Center for American Progress.

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