The first point is important because the absolute worst thing that could happen would be for the government to announce a plan that everybody wants to take part in. The banking crisis we have now would be nothing compared to what we will get if people are encouraged to stop paying their mortgages by a better deal only available if they are behind. The second point is important because it doesn’t help anyone if homes are abandoned. And the third point is important because it is necessary for us to get out of this recession.
One easy way to make the program undesirable is to put a bankruptcy or foreclosure on the person’s credit report if they take part in the program. Since they will be defaulting on the mortgage they agreed to, it seems perfectly fair for their credit report to indicate that they failed to pay off the loan as agreed.
Another way to make the program less desirable is to not write down the principle of the loan. Some portion of it can be set up as an interest-free, no payments loan, but anyone who enters this program should expect to have no equity in the home when they sell it. Given that the alternative is foreclosure right now, the borrower is still better off reworking the mortgage.
Assuming that the federal government will be taking over the loan, any reduction in payments will effectively pass the cost from the borrower to other taxpayers. As such, the payments should only be reduced as much as necessary for the borrower to be able to make them. But they should also increase later if the borrower’s income goes up (until the borrower is making full payments on the loan). The government already has an income-contingent repayment plan for student loans. The payments could be based on a similar formula. You consider the borrower’s household income (the income of everyone that lives in the house) minus some reasonable amount for non-housing living expenses multiplied by a fraction (something in the range of .3-.5). There should also be a floor set to approximately what the fair market rent for the house would be plus a little bit. Someone who can’t afford the fair market rent should move to a smaller, more affordable home.
Assuming that the principal of the loan has been left unchanged, all that is left is setting the interest rate. It could just be set to whatever the fair market rate is for 30-year loans. Or it could be set as an adjustable rate. But any interest above what the borrower can afford should be forgiven. If the borrower is paying fair market rents to the government, that should be enough without making the principle increase over time.
The benefit of this form of a workout is that anyone who can afford at least the fair market rent for their house gets to continue living in it. But they will have to pay as much as they can be reasonably expected to pay until the mortgage is paid off, so that people won’t have cause to complain that they are getting off easy.
The final point is that house prices have to be allowed to drop. In order for that to happen, the government should approve short sales, so long as the price is reasonably close to fair market values. Someone with a $700k mortgage on a house that is now worth only $300k should not be forced to find $400k in order to sell their house. But they also shouldn’t be allowed to sell their house to their brother for $200k just to cancel the debt. Again, the expectation is that if you are very far underwater, you aren’t going to have any equity when you sell the house. But you should still be allowed to move when you think it is necessary. It might be a good idea to have the excess debt tacked onto the next house that the borrower buys if they move to another house of a similar size nearby, just to prevent people from dumping their debt by moving down the street.
Another possible option would be for the government to encourage investors to buy homes with the current borrowers as tenants. The borrowers could specify how long they want the initial lease to be, the maximum they will pay in rent, and other things that matter to potential landlords (pets, children, smoking, etc). Investors could then bid on the houses at auction on the condition that they allow the current occupants to have a lease for the specified period of time. Investors could also be allowed to put in conditional bids that specify a higher rent. If none of the bids are high enough, the foreclosure process proceeds (or the workout plan above is tried).
The rental conversion option could also be available for non-government owned mortgages. The bank would get to decide if they would rather take the bid or go to foreclosure (it is their money after all). If some of the conditional bids are high enough but none of the regular ones are, then the occupants of the house can be given the option of the higher rent or moving out. The government would keep the conditional bids secret until the bank had rejected the original bids, so that the bank would not be able to force the rents to be higher than necessary.
These proposals can probably be improved, but I think they are at least a good starting point.