How increased mortgage interest relief can save the economy

October 27, 2008

(James L. Melcher is the president of Balestra Capital, a New York-based hedge fund. He co-authored this article with Joan McCullough, macro-economic strategist at East Shore Partners. Jim MelcherThey are writing in a personal capacity and the opinions expressed are their own.)

Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke have been behind the curve in dealing with the breakdown in the banking system and financial markets. All of their initiatives have had only limited impact as they persist in treating the symptoms and not the cause. We are in the early stages of a severe global recession. It is critically important to take more aggressive steps.

The most vexing variable in this entire crisis has been the value of underlying collateral. Any remedy, therefore, is ineffective unless we acknowledge first that the fate of the collateral lies in the hands of the borrowers. Thus, it is imperative that triage measures be taken without delay to ensure the survival of the mortgagors.

Recent government decisions assume that the banking system and financial markets are the center of the universe. Thus all efforts are focused squarely on these areas to the gross disadvantage of our citizenry. Paulson and Bernanke have clearly opted to address the current crisis by pouring ever-increasing amounts of money into the banks with a view towards boosting lending activity. With other financial entities, such as AIG, they have enacted similar liquidity enhancements in a gambit to forestall the forced dumping of illiquid securities, which they believe would threaten the entire global financial system. A functioning banking system is required; but so far official efforts have failed to seize an opportunity to shore up both the mortgagees and the mortgagors.

Personal income tax relief offers a solution that would benefit both targets. The tax-deductible allowance on all home mortgage interest on principal residences should be meaningfully expanded beyond the amount of the interest for a period of at least three years, with the greatest multiple awarded to households in the lowest tax brackets. For a family in the 20 percent bracket, a deduction of four times its mortgage interest would effectively cut their mortgage interest cost by 80 percent. This tax incentive would serve to keep families in their homes from a pure financial-relief viewpoint. It would also entice prospective buyers to buy a home without further delay.

Housing prices would start to stabilize and “bad” mortgages could ostensibly be nursed back to health, having an immediate, positive impact on lenders’ balance sheets. This Mortgage Interest Relief Plan would eliminate the need to transfer risk unnecessarily and unjustly to the back of the U.S. taxpayer. By implementing this plan instead of yet another Washington-originated, one-by-one refinance initiative, any fear-mongering suggestion of an expropriating action by the US government would be silenced permanently. Washington would also be able to recoup some of the credibility it has lost, as both homeowners and Wall Street will be in a position to offer kudos instead of scorn.

There are, of course, significant details to be worked out. But key here is that the plan be executed with a blanket approach. This broad scope removes from the equation the complaint that only bad behavior is rewarded along with other perverse conditions as set forth in earlier government programs. It has the forward benefit, too, of acting as a deterrent to the spread of foreclosure fever further up the socio-economic ladder; in a protracted global recession prime loans also fall under pressure.

Non-mortgagor taxpayers can be compensated with enhanced stimulus checks from Treasury, further facilitating the equitable nature of the proposal with a view towards jump starting consumption across the board. And by using the IRS to effectuate and monitor the process, it can be implemented expeditiously and relatively simply.

There would be substantial benefits to the financial system also. Rather than having Treasury or the Fed buy or lend against distressed mortgage-backed securities (much of which will turn out to be worthless), keeping people in their homes and current on their mortgages will raise the value of those securities and bolster cash-flow to their holders. The effect would be enormously positive, directly and indirectly, to the entire financial system and would substantially raise confidence levels. Instead of trying to control the smoke, we could start to put out the fire.

The cost of this program in lost tax revenues would be enormous. However, the amount of money that the Fed and Treasury are pouring into the financial system is already huge. While these recent initiatives are producing a tremendous amount of resentment as the costs to the taxpayer mount, they are producing very little bang for the buck. This Mortgage Interest Relief Plan may turn out to be both less costly and more productive than the current economic “rescue” program.

Financial systems run on confidence, and confidence has vanished abruptly. People are afraid to buy a home and they are panicking out of the markets. Speed is critical. We cannot wait for the current program to produce results, if it ever will.

A radical expansion of the mortgage-tax deduction is a blunt tool, but so is a sledge hammer. This forceful, proactive initiative puts the money where it is most needed – in the hands of individuals. It could be the shock treatment that both the economy and the financial system desperately need right now.


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How do we fire these CLOWNS????? We can NOT fix the problem when the Law makers are the same people as who handle the money. They make laws that they can not be punished for. Then they screw the people and make millions and we pay for IT. YOUR FIRED!!!!

Posted by Rik | Report as abusive

Unfortunately, as part of the Y generation, I think the “leave it up to the market” has played itself out. When it served us all to blame those that got themselves into ill-advised mortgages we did so. But now we’re of the general consensus that the bankers are at fault. Do terms like “corruption”, “predatory lending”, “exotic” financial instruments contribute to a solution to the current (early) phase of this Depression. On a global basis, the spiral of increasing unemployment in a tightened consumer-wary credit market, and rising education loan defaults bring greater relevance to Mr. Melcher’s thesis that the focus/consensus is behind the curve. A complete mortgage bailout won’t solve the problem if the borrowers don’t have jobs to sustain the smallest payment. If we cannot rely on traditional tenets, we must find a better way to do things. Perhaps a mortgage vehicle that’s guaranteed by our current social security program. Perhaps state subsidized private temporary agencies offering truly skilled workers. These are just quick examples. Whatever the case, its time to stop being behind the curve, throwing money and blame to get us to the next day of declining markets, and start proposing solutions to our collective crisis–before it becomes our personal crisis.

Posted by Peter | Report as abusive

Since it is obvious that the crisis started with the “predatory” practices of FNMA and FHLMC, lending to underqualified borrowers, it’s seems counterintuitive that more lending to underqualified borrowers would help. If you’ve ever wondered about the drawbacks of running a government backed agency as a charitable organization look at the $700,000,000,000 bill.

Posted by Mark Stouffer | Report as abusive

This is an interesting proposal, however unless the AMT is fixed it is likely that increases in the amount of mortgage interest deductions allowed will not have the result the authors believe. A more direct method would be to provide an exemption for mortgage interest paid with no limit provided it is for a mortgage on the taxpayors primary residence. The approach would not risk triggering the AMT for taxpayors with high deductions.

Posted by Denise | Report as abusive

Identify the groups of homeowners that are on the verge of default; speculators,foolhardy buyers and the low income buyer. In many respects this splurge was equivalent to the tulip craze! One must consider that many of those suprime mortgagors coulcn’t pay it if the interest rate was reset to zero. Those homeowners just can’t afford any home. Add to that those that are losing their jobs due to a faultering economy and the stage is set. What will a tax break due for those that could never make any payment?

Posted by Thomas | Report as abusive