The latest recession was primarily caused by the bursting of the housing bubble. During the rise of the housing bubble, home prices increased dramatically. When the bubble burst, home prices fell through the floor. This had a large number of really negative effects. Many homeowners who took out mortgages during the housing bubble wound up owing more on their mortgages than their houses were actually worth (i.e. they were underwater). Some of those homeowners strategically defaulted, leaving banks with huge losses. At the same time, the economic downturn left many other homeowners unable to meet their mortgage payments. Again, defaults resulted.

Underwater homeowners that did not default lost large amounts of their wealth, and were left with liabilities that drain their monthly budget. This hurts demand and has been a drag on the economy during the recession. To pull out of the recession as quickly as possible, an obvious policy objective should be providing relief to underwater homeowners. Getting rid of some of their mortgage liability will make them wealthier and increase their monthly disposable income, both of which should boost aggregate demand.

The problem of course is how to make this happen. Banks do not want to write down mortgages. Homeowners have no real power to write down their own mortgages. The only remaining mechanism appears to be government. So far though, government has been reluctant to provide any direct relief to underwater homeowners in the form of cash or pushing the banks to do write downs. However, there are two fresh policy ideas out there that, if implemented, would go a long way towards fixing the underwater homeowner problem, a fix that should also speed up recovery.

First, the New York Times has a piece detailing an idea from a California county to use eminent domain to ultimately help underwater homeowners. The idea is simple. Using its powers of eminent domain, the county will force banks to sell homes to the county at the going market rate. The county will then — through a proxy — resell the homes back to the underwater homeowners, this time at its present market value, instead of the price that obtained during the housing bubble. The end result of this would be less mortgage liability for underwater homeowners, lower monthly mortgage payments, and less foreclosures. All these results should improve the economy and life in the county, albeit by imposing significant losses on the banks.

Second, Matt Yglesias has a piece about a plan from Senator Jeff Merkley of Oregon. Under Merkley’s plan, the federal government would borrow huge sums of money to buy up all underwater mortgages. The federal government would then refinance those mortgages by either 1) shortening the life of the loan, 2) cutting the interest rate on the loan, or 3) cutting the monthly payment on the loan and extending the life of the loan. Homeowners would select one of the options depending on their specific need. Because the federal government can currently borrow at rock-bottom rates (the 10-yr real treasury yield is negative), the government has the ability to fund this huge buyout while still turning a profit.

The likelihood of the second one happening — as Yglesias points out — is very low. However, the likelihood of the first one happening — at least in some counties — is much higher. Even though underwater mortgages are a national problem, it is unfortunately much easier to address it on the county level than on the federal level given the current state of US politics.

Edit: Felix Salmon has a post explaining Merkley’s plan in more depth.