Reader Ken Melvin on Preventing Housing Bubbles

Reader Ken Melvin sends along an idea. My brain is just too fuzzy this morning to speculate, so I haven’t thought through the ramifications, but it does seem intriguing….

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Rather the Fed bailing out Market Street on the housing bubble, suppose the government implemented a scheme that tied the payments for those homeowner’s mortgages facing foreclosure to the home’s current value and stipulated that the rate of interest for the loan always be within a small margin of prime.

An example-model: Say that a homeowner purchase a home for $500k with 20% down leaving a principal of $400k financed initially with an ARM at 6% resulting in interest payments of $24k/yr or $2k/mo. If the interest rate went to 8%, the interest payments would be $32k/yr or $2.67/mo. All well and good if the price of the home continues to go up. Thus, the speculative bubble. But, if the price of the house went down 10% to $450k , the principal 0.8 x $450 = $360k and the $32k/yr is now 8.88% . Little incentive for the homeowner here. But, if the above scheme were implemented and the prime remained the same, the interest payments would be 0.06 x $360k = $21.6/yr or $1.8/mo. Unless they’ve suffered other losses, the homeowners would try their best to hang in there. A major consequence of this scheme is that the lenders are partnered in, making them less likely to fuel the speculative bubble. If applied in a perhaps somewhat modified form during those times when housing prices are rising too rapidly, the scheme could be used to take off some of the speculative edge that leads to bubbles.

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This was by reader Ken Melvin.