The current brute force approach of buying up doubtful mortgages however may be an unnecessarily drastic solution to a relatively short term problem. (short term relative to the term of the mortgage)

If the defaulting (or soon to default) home owners could be rescued from the dilemma having to pay down mortgages that greatly exceed the value of the house during this dip in home prices, they would be encouraged to continue paying down the mortgage. If the defaulting owner’s payments could be reduced to amounts that were commensurate with current appraised value – if the payments tracked appraised value – then they would be much less inclined to default.

For example, 1.5 million 30 year mortgages written for an average of $500,000 each amounts to $750 Billion. The total mortgage payments for the $750 Billion amount to about $48 Billion per year. To consider an extreme, assume these mortgages were written with no money down. If suddenly home prices dropped 33% then the mortgagee would feel he was paying mortgage payments that were 50% too high ($32,000 instead of $21.312 per year) and may be tempted to default. If the government (by whatever means) picked up the $10,667 difference the home owner would be inclined to continue. In this example the 33% drop in home prices would result in government supplying $16 Billion cash that year to prop up the mortgages.  If the following year the appraised values were 80% of the original amount, the government would supply $9.6 Billion. If the fluctuating dip lasted five years the government might have injected about $60 Billion. Nothing like the $750 Billion cash requested by the Administration would be needed up front nor is it likely to be needed over time.

The $60 Billion in the example is not proposed to be an outright gift however. Here is a description of a government participation program:

1.    The present owners of the mortgages (the banks etc.) will select the mortgages they want in this program (these banks continue to own the mortgages and they are taking a hit of x% in this program so they won't be inclined to expand the program beyond what is needed.). This eliminates the role of the government in selecting who gets on the program and lets the people who know the most about which mortgages are problem mortgages, do the selection.

2.    Holders (banks etc.) must agree to change all mortgages in this program to fixed rate and to reduce face amounts by x%.

3.    Calculate what the owner would be paying had the mortgage been written for today's appraised price.  Then calculate the difference between the size of the mortgage payment he would normally pay and this program's (reduced) mortgage payment. Let's call this the "payment difference."

4.    Give the home owner a (non-cumulative) income tax credit for y% of the "payment difference." (In the example presented above, y equaled 100%.)

5.    In return for the income tax credit, give the government some participation in any gain realized when the house is resold. (Stanford University has had an assistance program like this in operation for some time. It was designed to help faculty cope with high housing costs in the area. Study this as a guide)

Advantages:

1.    When home prices recover completely the tax credits will automatically disappear so the government “bail-out” is self-configuring in magnitude.

2.    The instrument holders’ (the banks) losses will be limited and quantified.

3.    The participating home owners who pay taxes will be benefited and will be inclined to hold on to the homes.

4.    Home owners who don’t pay taxes and probably couldn't afford the house in the first place will not be benefited in the same way but will be permitted to transfer the mortgage including its tax credit arrangement to new owners who do pay taxes and who therefore would find the arrangement attractive. Since selling would still net some money to them, the old owners would be inclined to sell rather than just walk away.

5.    The advantage of non-cumulative income tax credits is that the government cash outlay isn't a large budget allocation that has to be estimated in advance and it will automatically be reset each year to an amount that is no more than it has to be that year.

6.    The “participation” part of the arrangement can recover tax revenue lost to the tax credits. Long term (when the house is resold), the Government can recover some or all of the tax credits and has a possibility of realizing some gain on investment.

7.    The plan has far less chance of abuse than cutting a check for $750 Billion up front with poor visibility and limited accountability