The Frank Dodd FHA Proposal is Probably Good Policy

Because house prices have fallen (nearly) everywhere, it is hard to make a case that underwater mortgages are now principally the fault of irresponsible borrowing. Something like an exogenous event has affected many homeowners who bought houses they could actually afford. These homeowners have an incentive to walk away from their mortgages, and as a matter of policy, we really don't want to do so.

A proposal where FHA insures mortgages that borrowers can afford at 85 percent of house value gets the incentives more or less right going forward. Lenders take a haircut, but not an acceptably large one, and borrowers have an incentive to keep paying. At the same time, because the government would recoup any unexpected profits arising from the scheme, it does not provide borrowers with the potential for a taxpayer guaranteed windfall. In the overall scheme of things, the proposal is clever, and may be quite helpful.