Our financial system is tested by its ability to resolve contradictions. For instance, banks hold loans and other illiquid assets against short-term liabilities such as deposits. But, after many highly destructive crises, that contradiction was resolved by legislation creating the Federal Reserve System, to provide liquidity for good bank assets. It's profitable.

Another contradiction is "Your home is your biggest investment." Purchase of a home is not an investment decision, it is a means of obtaining and controlling your family's housing. If you reach this goal by putting 0% or even 10% down, then you're primarily investing someone else's money — in the world's largest accumulation of illiquid assets.

We can't much change the preference of households to own their homes. And ownership is the obvious way to vindicate individual choices about maintenance and enhancement of residences — choices that can substantially affect their value and are not consistent with rental.

However, the consequence of this is that with home prices declining from 2006 onward, over 20% of homes are now estimated to have a lower liquidating value than the balance on the mortgages they secure. In some areas, as many as a third of the homes are "underwater."

Who's going to wind up holding this wet bag — and for how long?

But first — does it actually matter how or whether these underwater mortgages are resolved?

For every house that is foreclosed (and therefore virtually certain to generate loss to the mortgage holder), there are 10 others on which payments continue to be made by the owner, though the mortgages are underwater. Despite incessant publicity about strategic default and delays and legal vulnerabilities of the foreclosure process, an overwhelming majority of these homeowners still want to retain their homes and credit. So, they will go on, for now, making payments if they can afford to do so.

In theory, these people can't sell their homes without making up the deficiency of sales proceeds versus mortgage balances. Even if they could cover this gap with accumulated savings, where would they find the higher down payment now needed to buy another home?

If you can't sell your home, then you can't move to one that is better suited to your needs or which is nearer the job you should take. This partial freeze on moves, like any restriction on changes in assets and employment, has negative consequences both for household welfare and for the growth of the economy.

If 20% of homeowners are affected — and in any one year 12% of these would have moved were they not underwater — then 2.4% of households are frozen. That's a modest percentage. But as years pass and increasing numbers of people wish to move but can't, the cumulative adverse impact multiplies and can become very substantial.

Can the market resolve this contradiction? It cannot do so unaided.

To see the obstacle, consider the simplest case. Suppose the bank that originated the mortgage continues to hold it in portfolio. The loan is current on its books. But, for every $100 of book value, there is now only $75 in collateral value, so the loan is partially secured. (That's not bad, compared to a loan on an expensive new car! But no one proposes to write down those car loans.)

The bank can't and shouldn't let the borrower off the hook for the remaining $25, any more than if he had bought stock on margin or invested in commercial real estate and then suffered a large loss. But, suppose the borrower now wants to move to a different house of comparable value.

In that case, the bank could simply substitute the new collateral for the old — and charge a fee. Payments would be adjusted for any change in interest rate. If the new home sold for less than the old, the difference would be applied to the old mortgage balance. If it sold for more, the homeowner would need to pay the difference in cash.

If the owner wanted to sell the old house before or without buying a new one, the proceeds of the sale would be held by the bank. The owner would remain responsible for the portion of his original home payments not covered by the liquidated collateral (in our example, approximately 25% of the monthly payment amount).

The market cannot accomplish all this unaided because in fact the mortgage is typically owned by a trust. The servicer, as agent for the trust, typically is not permitted to carry out transactions such as I described.

Let's change the laws to facilitate (but not compel) such transactions, when they are in fact in the interests of the mortgage owners.

Any lawyer who insists that the note and the mortgage are merely differing manifestations of the same underlying essence should be sent back to school — divinity school.

Andrew Kahr is a principal in Credit Builders LLC, a financial product testing and development company. He was the founding chief executive of Providian Corp. and can be reached at akahr@creditbuilders.us.com.

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