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Opinion

With a little help from Congress, homeowners could come to their own rescue

Congress should change the rules and let homeowners break into their retirement funds.

By Raymond P.H. Fishe / December 3, 2008



Richmond, VA.

The U.S. Treasury and Federal Reserve may need more than $700 billion to shore up bank balance sheets and restart the economy. So far, the ideas from Congress are doing nothing to improve the current dismal economic outlook.

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Instead of pouring capital into banks and trying to rescue homeowners who cannot meet their mortgage obligations, Congress can make a simple change to the tax code and let homeowners come to the rescue.

Banks and investors hold many more good than bad mortgages, but right now banks need extra capital and liquidity to adjust for deleveraging and expected loan losses. Homeowners can help if Congress allows them to restructure their own balance sheets.

Homeowners held $11.2 trillion in mortgage debt at the end of June. They also held about $17 trillion in retirement assets – IRA, 401(k), 403(b), Keogh, etc. – at the end of March. Unfortunately, these retirement assets are smaller now, but more unfortunate is that these assets cannot be used without penalty before reaching age 59-1/2, excepting hardship cases, first-time home buyers, and specific educational purposes.

Congress should change these rules.

Here's one idea that could really work: Let homeowners withdraw up to $200,000 from retirement accounts to repay mortgage debt without penalty and without incurring an immediate income tax. The withdrawn retirement funds will reset the home's basis for tax purposes. When the home is sold, the owner should then owe tax if the resulting capital gain exceeds the current $250,000 (single) or $500,000 (married) exclusion.

For example, suppose a homeowner who paid $180,000 for his house 10 years ago still owes $120,000 on the original mortgage and has close to $400,000 in retirement assets. If this person transfers funds to pay off his mortgage, then the basis of his home is reduced by $120,000 to $60,000. When he sells the home, gains would be computed against the new basis so as to include the transferred retirement funds.

Why would homeowners do this? In the current crash environment, homeowners hold low-yielding liquid assets for investments, while still facing relatively costly interest charges on their mortgages. The transfer of retirement assets relieves them of this costly burden, and thereby effectively earns them more than low-yielding money-market funds do. In addition, they may avoid some future taxes on the transferred retirement funds because of the home sale exclusion.

In this scenario, the economy gains because lower mortgage payments increase homeowners' monthly cash flow. And some of this cash will flow into much-needed consumer spending.

How would this help banks? They and other mortgage holders would receive sizable principal repayments that liquefy the asset side of their balance sheets.

Right now, the markets for mortgage assets are under strain, so banks are reluctant to sell assets to raise cash – even the well-performing ones because of moral hazard discounts. Repayments would solve the problem and could be put to use in productive new loans, many of which would potentially earn more than what they received from homeowners' mortgage payments.

How would this help Congress serve the public? This approach would not be free of cost, because the Federal government would forgo future taxes on some retirement withdrawals. These are real losses, but also somewhat speculative – because of the option retirees have to wait up to age 70-1/2to begin withdrawing funds. These lost taxes are only a small fraction of the dollars used to repay all or part of mortgage balances. Thus, one dollar of increased assets in the banking system via mortgage repayment would cost only a small amount to the US Treasury. Currently, our assistance programs are costing taxpayers a dollar-for-dollar charge when we assist the banks.

Who is hurt? Mutual funds would see a reduction in retirement assets under management and lower fee income as a result. Certainly, this is a concern, but if this helps put the economy back on the path to growth, the recovery in stock prices will help to offset these retirement fund transfers.

Raymond P.H. Fishe holds the Patricia A. and George W. Wellde Jr. Distinguished Chair in Finance at the University of Richmond.

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