The Mortgages of the Future

In this time of economic crisis, help for troubled homeowners often arrives late, when it arrives at all. All too frequently, families are going into default on their mortgages, facing foreclosures and evictions that may have traumatic consequences.

It doesn't need to be this way. Mortgages could be structured differently, so that adjustments in payments would be made as a matter of routine -- systematically, automatically and continuously -- starting even before any distress is perceived by borrower or lender. By avoiding thousands and even millions of individual family crises, we might also make institutional crises, like the collapse of Lehman Brothers and Bear Stearns, less likely.

We need to innovate, with the creation of "continuous-workout mortgages." Such mortgage contracts, when originally signed, would specify a program for steady adjustment of the balance and payment schedule over the life of the mortgage, enabling most homeowners to continue to afford to make payments and maintain some home equity, even in harsh economic circumstances. These contracts might become the standard, with automatic adjustments based on shifts in national housing-cost indexes and futures markets (I've been involved in creating both), as well as economic indexes like the unemployment rate.

Continuous-workout mortgages would be privately offered. They would not be bailouts; the cost of workouts would be priced into the original mortgage rate. This transparency has a great advantage: when the actual risk to the investor is explicit from the beginning, mortgages are less likely to be initially overvalued in the market, and so the kind of financial crisis we are experiencing now would be less likely. It is, after all, the rapid decline in value of subprime mortgages, and of derivative financial instruments based on them, that has wreaked such havoc in the global financial system.

The cost to mortgage lenders of providing continuous-workout mortgages may actually be negative. That's because the workout provisions would help prevent the costs of forced sales of homes, associated litigation, inadequate home maintenance and damage to the properties, and associated neighborhood collapse, which can create serious losses for mortgage lenders. Anticipating lower costs on these fronts, originators of continuous-workout mortgages may be willing to offer more attractive terms to borrowers from the beginning.

A major innovation like this would need government help. Earlier this year, Congress passed the Housing and Economic Recovery Act, which promised to bail out as many as 400,000 homeowners who could not pay on their mortgages. But the act made no fundamental reform of the mortgage market and included no plan to prevent more of the same problems from appearing.

In the past, Congress has been more inventive. During the housing crisis of 1933, for example, Congress created the Home Owners' Loan Corporation to force some fundamental shifts in mortgage institutions. The HOLC swapped its own debt, which was guaranteed by the government, for mortgages of defaulting homeowners, and it reissued mortgages with some important new features. The new loans had a 15-year term and were self-amortizing -- that is, the homeowner made the same fixed payment each month until there was nothing more to pay.

This was a huge change. Until 1933, home mortgages in the United States generally had terms of three to five years, and homeowners had to go back regularly to refinance them. If a mortgage could not be refinanced -- because the homeowner was unemployed or because the price of the home had fallen too much relative to the loan amount -- a homeowner had to pay back all principal, typically a huge payment, or lose the house.

The HOLC changed this, effectively establishing a new conventional mortgage that the private mortgage lending industry then embraced. To this day, long-term mortgages are the norm, and, in fact, 20- and 30-year mortgages have become commonplace (although the popularity of adjustable-rate mortgages with artificially low initial "teaser" rates have exacerbated our housing problems).

The government did not finish the job of improving mortgages in the 1930s, even though some had begun to see what should be done then. In a 1931 article, for example, Professor Irving Fisher of Yale argued that more flexible instruments should be substituted for conventional debt. "The principle of sharing risks must be extended," he said, adding: "Bonds and debts are rigid. We need more elasticity. Then there will be less of 'breaks' and 'crashes' and 'crises.'"

But neither Congress nor the private sector took his advice then. We might not have today's financial crisis if they had grasped back then how to provide such elasticity and had established even better mortgage conventions. We have the intellectual tools to do so now.

Neither presidential candidate has announced a plan to transform our mortgage institutions so they work better for our people. Such plans may not be fodder for election campaigns. They might be implemented after further discussion at the beginning of a new Congress and a new administration. It is time to set the stage for a better mortgage contract.

Robert J. Shiller, Arthur M. Okun professor of economics at Yale and co-founder of MacroMarkets LLC, is the author of "Subprime Solution: How Today's Global Financial Crisis Happened and What to Do About It."