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.

25 comments

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This suggestion offers some promise of curbing the downward spiral, IF (a big one) exotic-structured mortgages, debt securitization, and derivatives are curtailed–i.e. forbidden.

Without the later, more dollars (from reduced tax revenues) will simply flow into the debauched process of home creation, financing, and attempted personal ownership.

A-to-Z MORAL reform is necessary, not the Treasury and Federal Reserve creating more credit-based money to fight the problem of tight liquidity.

Posted by Dan Smedra | Report as abusive

You must be kidding? Another person who wants to transfer wealth from those who worked hard. This time to those who should never have got in over their heads in debt. Please get your hands out of my pockets!!!

Posted by Red Hen | Report as abusive

Dear Editor:

I have been surprised that more has not been done to help Americans instead of Corporate Board’s who greedily knew what they were doing in chasing returns that could never sustain themselves when the loans reset. I guess the idea was to dump it on the secondary market and let the Government bail out everyone. I believe no one guessed the fall out was going to be so deep and global.

I would like to propose a second layer to mortgage interest deductibility plan that would address the true root of the current credit crisis. My plan is obviously just a starting point but would involve a direct loan to Lenders to being their loans in default current. The framework of this plan would involve a tax lien placed on the home that would guarantee that tax payers are repaid in the future with IRS oversight. My vision of the plan would be to lend to homes at up to 25% of their current value with a maximum cap of $100,000. The program would then lend up to $100,000 to a homeowner where an impound account would be established with the Lender and all money is used toward bringing mortgages current and any remaining money left could only be used for paying future mortgage payments. The Government would then place a tax lien against the property and would thus be the first to be paid when the property sold with a rate equal to the 10-year T-Bill. Like all other tax issues, the IRS could easily follow this tax lien.

The above Government Lending Plan would have, in my opinion, a similar affect as increasing the deductibility of mortgage interest but would focus on the real issue of getting money in the hands of Lenders and bringing Mortgages up-to-date to stabilize the system. At $100,000 a home, if 1 million homes took advantage of this program, $100 billion would be infused directly into the actual Lender’s from a bottom-up approach that would stabilize the housing market. This same format could be used for commercial paper and other types of loans with real property as collateral.

Keep up the great work:

Mark

I disagree, It takes more to own a house than paying the mortgage. Keeping up the property takes money. I agree with Pres Bush in this one area, the people that should not have gotten a mortgage should return to rental.If one can wait long enough these toxic items are real property and will go up allowing for much that now appears lost to be recouped.

The housing industry like the health care industry needs to be completely revamped.

There are too many middle men involved in the process each one taking their profits all on the back of the consumers. And there is no one except the consumers to blame for buying the homes that they are building.

The concept of homes in subdivisions. A builder buys entire piece of land in the path of development forcing people to buy homes from them. They control the area, land, type of home and of course price and financing. The price of these homes are often too inflated as the consumers have few options except to buy from them.

Once these stick homes are built, they are under pressure to sell. They entice consumers in cooperation with banks with teaser start up interest rates to off load their inventory to the consumers and make quick profits.

Too often the lending standard were relaxed to aid the absorbency of the homes. The banks first off all were financing these expansive speculative developments as they were bringing great ROIs from the builders and second from mortgages they were financing to individual home buyers. The home buyer was able to borrow money that was significantly more than the value of the home as a result of lenient lending standards. That drove the cost of homes artificially up.

Price has to reflect the true value of the collateral. It did not. The economy could not sustain it.

This is a proposal to bail out the hedge fund that wants to see the value of its securities upheld. The problem began with the notion that real estate must appreciate, a notion supported by the current tax structure. The appreciation was unsustainable, but was supported by unregulated products with which Wall Street flooded the mortgage market.

The beneficiary of this proposal is the owner of mortgage backed securities, at the expense of the homeowner who will pay for their overvalued asset for another 25 years. Let the values fall to the point where average income qualifies for a loan to buy the asset. Let the banks take the hit and continue to learn their lessons. While the dice were rolling hot, the hotshots from Wall Street kept doubling their bets, and its time to let the chips fall where they may. That means those on the “upper socioeconomic” ladder have less, which means ultimately, that the unfettered market has corrected itself.

Posted by James Neumerski | Report as abusive

The crises startet in the financial world.Sart there to restore it.A central control point in the USA for all fin market paricipants,including the hedge funds,stop futuretrading that create most of the volatility.
Regards

Posted by Ben Kok | Report as abusive

I think we all know what one of his long-positions is!

Mr. Smedra is onto something. How did we get to here…”No credit, no problem” that’s how. Run the numbers back and we find irresponsible, un-credit worthy borrowers being preyed upon by dubious lenders offering them the opportunity to live the high life…saving up for the item is for suckers, use this card to pay off this other card and stay ahead of the interest payments…of course the debt finally catches up to them and then a new industry sprung up to allow these borrowers to “cut your losses at pennies on the dollar”… But who got stuck paying for the rest of the dollar? The guy playing by the rules.
Same thing in the housing market, artifically inflate the price of the house, offer unqualified people access to a house far exceeding their means to pay, a little math, a little magic and presto, a loan appears and the fun begins. With no adult in the room kindergarteners will not behave, such was the housing industry. The lack of honor and honesty, the lack of fiscal discipline, the lack of leadership and oversight coupled with a lack of a moral compass all point to this the root cause…insatiable greed and gluttony coupled with envy add up to three of the original deadly sins. Deadly you ask, yes, they almost killed the economy.

Posted by bob reaves | Report as abusive

why on earth are we still listening to them ! FED caused this mess by artificial low interest rate, all this paper money created out of thin air by FED and commercial banks via muliplication of deposits was fictious capital which is now disapearing, the recesion itself is the only cure, going forward we need sound money backed by commodity and banks to keep 100% reserves on deposits

http://www.mises.org
http://www.mises.org
http://www.mises.org

It seems that there are two camps of responders here. I fall into the kulsum/James camp. Mortgage interest deductions have served to distort the market values of all homes. Those Americans who bought homes that they could afford are not even able to deduct the interest since they do not itemize. The key to solving this crisis of government intervention is to have less government intervention. Let’s consider ways to shift to a tax system that encourages us to act in a way that is responsible. As James says, let the market correct itself. Maybe more accurately, let’s get rid of the wacky exemptions so that we have a market.

So your plan is to give tax breaks to people who cant afford to be in the home they bought. For how long? 30 years? If they can’t afford it now, chances are they won’t be able to 3,5, or 10 years from now.

The best thing in the long run is to get these people back to renting NOW. Why prolong the recession by stringing out the foreclosures over the next 10 years, spending trillions of tax payer $$ in the process, only to get to the same place in the end. That is, getting the national homeower percentage back to 31% (where it was for 80-100 years), from the approx. 39% it is now. The 8% should be renting, not owning, since they cant afford the mortgage or property upkeep anyway.

Another short sited expert. You’re the reason we are all here now.

Posted by Mark | Report as abusive

Re: comment by “Neumerski” is very good. The current market value of these mortgages is absolutely artificial, and no amount of money, in any kind of program, will change the unyielding force of economics in establishing their actual “market value”. Witness the record home sales (to qualified individuals) this month, with lower prices. Leave the economy to settle itself out, and keep the pontificating, finger-pointing, vote-buying politicians away from it. Why should all of “us” who were hard working and honest in our applications, be made to pay through taxes (because of the politicians), the phony mortgage down the street? Further, if hedge funds, derivative sellers and the like lied about the value of these mortgages to unload the paper, then isn’t that fraud? The real tragedy here is a total lack of accountability, while taxpayer money is being shoveled like coal, into the engines of this political Titanic.

Posted by econo-mist | Report as abusive

Median family incomes in the US have been static in dollars and declining in real terms for the past ten years or so. If the proportion that a family will spend on a home remains the same then house values cannot increase and will decrease (if adjusted for inflation) and continue to do so ad infinitum. Further, if other items in a household budget increase and the income remains static then the proportion available for home payments must therefore shrink. The question is why are medain incomes declining? The answer is that the US has outsourced its middle class and their jobs primarily as a result of unfair trade with China. Policymakers ignore this fact at their own peril.

Posted by Nick | Report as abusive

I am afraid the American people are in a kind of denial which is more like a death spiral. Nearly everything in this debate is related to abating symptoms without addressing underlying causes. The problem is not securitization, which is a great innovation in financing, or making loans to low income people, or even having low interest rates…. These things benefit society. The problem is corruption that results from the leadership sending the message that for business, anything goes. When the less savory characters who inhabit the world discover that no one will slap their hands for cheating and corrupting the system for their own personal benefit, then the unscrupulous will run amok and make ordinary people feel like fools for not doing the same.

This is the legacy of Bush/Cheney and the Republican complicity. Folks, these people have betrayed the country through an ideology that places selfishness at the top of the list of virtues. When a society becomes so skewed toward self-serving behavior it cannot avoid collapsing upon itself. The U.S. needs to get its act together or kiss any hope of sustaining a decent standard of living goodbye.

Posted by Jonathan Cole | Report as abusive

John Cole nice post, I couldn’t agree more. I curse myself for not living in a tax payer financed $750,000 home with a Hummer & BMW in the 4 car garage. (Goes with last sentance of your 1st paragraph.

The only thing I’d add is that it isn’t only Bush and the Repub’s fault, but congress also. It’s presonal greed from all of our elected officials who do not care about the average citizen once elected. How many of these same corrupt politicians will be re-elected by our idiot population next week?

We are more efficient then Rome, it only took us 232 years to destroy our civilization! The past is destined to repeat, since people spend all their time watching American Idol. America has gotten to entitled and lazy.

Posted by Mark | Report as abusive

I agree that there is a root cause not being addressed. I also believe that PROSPERITY and TAXATION go hand in hand. Of course, this depends on who is charged with paying America’s bills. If America’s tax burden is placed on the vast majority of Americans, i.e., the consuming Middle Class…then consumption of everything from soup to nuts decreases, and prosperity is not going to be the long-term result. The reverse is just as true.

In my view, the root cause not being addressed is simply not following the BASIC MODEL for the U.S. progressive tax system (and thus American prosperity) begun in **1913…and which survived the Great Depression and two world wars.

American prosperity is a mirage unless America’s bills are paid, and America’s debt minimized.

The obvious major symptom of the root cause is the present massive national debt ($12 Trillion) fed by annual federal budget deficits (currently at least $1 Trillion). The United States was getting back on the right track toward the end of the Clinton administration…and thrown completely offtrack during the ensuing Bush administration.

It is a Reagan ideology that we’re dealing with here. Mr. Bush has been simply following tax policies begun during the Reagan administration in 1981. Mr. McCain wants to continue these policies. Mr. Reagan’s “landslide” election with only 50.7% (44 million) of the popular vote, but 91% of the electoral vote enabled him to persuade a democrat-controlled congress to turn America’s **practical and rational progressive tax system on its head.

The manifestations of just how far offtrack things have gotten became especially apparent during the past year or so.

So, what is this BASIC model for American TAXATION & PROSPERITY? Well…the basic model that the U.S. began in 1913 is an untaxed & growing Middle Class whose members consume the products that they produce in production facilities owned by a Privileged Class, the latter’s personal income, net profits & capital gains being taxed to pay America’s bills and keep its debt minimized.

In other words, America’s bills get paid and both the Middle Class and Privileged Class prosper together (while the Working Class shrinks). I believer that if there is an Obama administration, that America will get back to the **BASICS.

OK Jack

**The 16th Amendment to the Constitution was ratified in February 1913, and the Revenue Act of 1913 was signed into law in October 1913. The constitutional amendment was proposed to the several states by a republican president (William H. Taft) and a republican-controlled congress (with the tacit approval of America’s $billionaires, e.g., Andrew Carnegie of U.S. Steel). Said democrat (Woodrow Wilson/Oscar Underwood) revenue act did not tax the Working Class or the Middle Class. As a matter of fact (in today’s dollars), the first $66,300 for singles and $88,400 for married working couples was not taxed.

Let’s get real…

The real cause of this whole problem wasn’t the aggresive lenders… it was the idiot that thought he could handle paying for a $400K home when he was a temp. employee as a plumber in Mich. C’mon, America is all about who to blame. Blame Blame Blame – it’s your own fault you’re in this mess. You shouldn’t have been trying so hard to keep up with the Jones’.

Posted by Jeff Jones | Report as abusive

I think the solution has been right under our noses the whole time. We have left the most essential and needy people to fen dfor themselves while banks and other business have their cake and eat it too. Stop giving these corporations breaks. They deceived people with these loans and now they are getting rewarded for it.Enough is enough. Nobody needs and deserves more the help than the people that would use it to get the econmy moving again……

Posted by Alex Munoz | Report as abusive

Any debt’s that have been depreciated on bank balance sheets should have their payments restructured to reflect that. Make a special provision (lien) on capital gains so if if the underlying asset appreciates above the new, depreciated level the the loan issuer is the first beneficiary. Up To the original value or course.

As it is now, only one party takes advantage (or disadvantage as bleeding balance sheets demonstrate, while the possible benefits are no where to be found. Bad debt recovery should occur occasionally not chronically.

Posted by Glen | Report as abusive

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