A free market solution to the mortgage mess?

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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