$300 Billion, Better Spent...

Republican presidential candidate John McCain’s $300 billion proposal to buy up failing mortgages, announced during Tuesday’s debate, likely caused the likes of Milton Friedman and Ronald Reagan to do yet another flip in their respective graves. McCain’s proposals regarding the crisis thus far have not been infused with minimal-state, market-based solutions, which perhaps should not be surprising for a man who idolizes Theodore Roosevelt. But as active-state solutions go, a rescue plan directed at individual homeowners, rather than financial institutions on the macro-level, need not be overly offensive to capitalism.

McCain should form a proposal around the following parameters. When homeowners are in the midst of refinancing, which usually occurs these days at the expiration of an adjustable rate mortgage period where the homeowner is unable to afford post-adjustment mortgage payments, and the property appraisal comes in under the value of the existing mortgage, the FHA would offer to step in and buy down the difference between the mortgage amount and the property value. In exchange, the FHA would obtain a lien on the property for the amount of the buy-down. If the property is subsequently sold for an amount greater than the appraisal value at refinancing, the margin would be paid back to the FHA by the homeowner up to the amount of the FHA’s buy-down.

As an example, say a home with a $300,000 mortgage is being refinanced, and the new appraisal is at $280,000, leaving a $20,000 shortfall. The homeowner would have the option of allowing the FHA to buy down the prior mortgage to $280,000 in order to allow the refinancing to proceed. If the homeowner subsequently sells the property for, say, $320,000, $20,000 of the profit goes to the FHA and $20,000 is kept by the homeowner. The homeowner is allowed to stay in the home, the lending bank is spared a foreclosure sale, and the government is given a chance to, and in most cases should, recoup its $20,000 buy-down.

More importantly, the fear of further foreclosures pushing down mortgage-backed securities and endangering the banking system would subside. Combined with a change from the mark-to-market accounting rule, such a foreclosure buy-back program could go a long way toward alleviating the irrational fear now pervading financial markets, and without significantly compromising free market ideals.