Forced debt to equity conversions have been proposed as a solution to make insolvent banks solvent again. The idea is that some portion of a bank’s outstanding debt is converted into equity in order to restore a positive net worth (assets – liabilities). There’s no reason why this same approach could not be taken with private homeowners.
Let’s look at a simplified example:
Home purchaser takes out a $100k bank loan to buy a $100k house.
Assets = $100k, liabilities = $100k, net worth = $0.
House price drops to $80k. Now:
Assets = $80k, liabilities = $100k, net worth = -$20.
Undertake the debt to equity conversion:
Loan reduced to house market value = $80k.
In exchange, bank gets $20k equity = ($20k/$80k) = 25% ownership stake in house.
The homeowner essentially gives up 25% of future increases in home value in order to not be underwater now.
At some point in the future, the house will be sold. When that happens, one of the following scenarios will play out.
Scenario 1 – House sells for <$80k. Bank gets fraction of its $80k loan back. Bank gets nothing on its equity. Homeowner gets nothing.
Scenario 2 – House sells for $80k. Bank gets all of its $80k loan back. Bank gets nothing on its equity. Homeowner gets nothing.
Scenario 3 – House sells for >$80k. Bank gets all of its $80k loan back. Bank gets 25%*(Home price – $80k) on its equity. Homeowner gets 75%*(Home price – $80k).
At a sale price of $160k, the bank recoups all of its initial loan ($80k modified loan + 25%*$80k = $100k). The bank makes a net profit on any final sale price over $160k.
The homeowner will also receive an option to buy out the bank’s equity at any point in the future for 25% * (Market value – $80k) plus some pre-determined premium.
This program would be open to all homeowners, banks would have no say in the matter. Obviously, homeowners who are not underwater would not have any reason to participate.
Is this solution perfect? No.
Is it preferable to a taxpayer-funded mortgage forgiveness program whereby the government pays banks to forgive a portion of underwater loans? Yes.
Is it preferable to doing nothing and having the debt overhang doom the economy to a decade or more of below-potential GDP and high unemployment? Yes.
I’m well aware of the difficulties involved. The loan writedowns would impair bank earnings for a period of time (though there would now be future upside). The impact on mortgage services, MBS, CDOs, and the holders of MBS and CDOs would be messy. There would be lawsuits. Again, it must be measured against the alternatives and not some utopian fantasy world where all debts will be eventually paid in full and no losses have to be taken.
What I’ve laid out above is a simplified, stylistic version. All sorts of modifications could be made to improve it. The percentage of debt converted could be increased to provide additional monthly payment relief. The equity structure could be modified to give the bank a bigger percentage claim on the first $20k in price appreciation. Other terms of the loan could be modified. The point here is just to lay out a set of guiding principles; the details can be hashed out later.