A free market solution to the mortgage mess?

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Writing on DealBook, Paolo Pellegrini has an idea for dealing with the more than 20 percent of homeowners who are upside down on their mortgages. It works like this:

Homeowner Smith has a $350,000 mortgage on a house worth perhaps $250,000. Mr. Smith petitions the bankruptcy court for a mortgage restructuring. The judge sets a date for submission of sealed bids for his property. Mr. Smith approaches newly created private mortgage lenders to obtain a post-restructuring mortgage. After reviewing Mr. Smith's finances and property, XYZ Capital offers to lend him $245,000 at 7 percent for 30 years. ABC Capital offers $260,000 on the same terms. Both lenders -- a hedge fund and a private equity firm -- are getting 90 percent of their mortgage-lending funds on the cheap from the government through a repurposed Term Asset-Backed Securities Loan Facility program. They get no government guarantees or insurance. The low-cost money enables them to offer Mr. Smith a better deal.

This solution works, and it doesn't put the United States taxpayer in a position to guarantee loans or buy up crap securities at inflated prices. It allows underwater "homeowners" (if you're underwater, what exactly do you own?) a chance to stay in their homes -- as long as no other prospective buyer is willing to pay more -- and doesn't burden them with a temporarily low monthly payment on a mortgage that is still too high for the actual value of the house.

This is the problem with the vast majority of loan modifications being done right now: they don't leave the borrower in a position to build equity. Mr. Pellegrini's plan solves that problem.

Banks and mortgage holders take a substantial loss, but it's quick and then it's over. Homeowners get a true chance at a fresh start, and taxpayers aren't the dumping ground for half a decade of bad decisions. The only problem is that it makes too much sense to ever be taken seriously in Washington.

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