The United States is four years into the housing recession and there is still no sign of recovery. Prices keep falling nationally despite local markets that have stabilized or are inching up. Years of mortgage modification and refinance programs have helped thousands while failing to stanch the ongoing flow of millions of foreclosures.

Low interest rates are allowing those with the best credit and with equity in their homes to save money while leaving those in the most need of help—those, that is, whose homes are underwater or who are struggling to make ends meet—without relief. Meanwhile, the economy continues to see a modest but jobless recovery.

Historically, it is housing that turns a recession around, but that seems unlikely to happen this time. Instead, the failure of the housing markets to find a bottom, to create the demand needed for increased production and sales, and to work through the excess supply is leading a growing number of economists and others to come to the view that something more fundamental is needed—namely, writing down the loans of those homeowners who are underwater.

Floyd Norris in a recent New York Times article quotes Kenneth Rogoff, a Harvard economist, as saying, “There is widespread agreement among economists that housing debt is at the heart of the slow recovery… and that finding a way to bring it down faster would accelerate the recovery.” Some, like Larry Simons, a former Assistant Secretary for Housing/Federal Housing Commissioner, have advocated paying down mortgages for several years, arguing that neither the administration nor Congress has yet understood the magnitude of the crisis or been willing to take the major steps needed to revive the markets. Others are just now coming to this view.

For instance, Martin Feldstein, a professor of economics at Harvard and chairman of the Council of Economic Advisors under President Reagan, recently wrote in the New York Times, “…the only real solution [is] permanently reducing the mortgage debt hanging over America.” William Dudley, the president of the Federal Reserve Bank of New York, in a speech in November at West Point, recommended, among other policy options, that “. . . borrowers who are ‘underwater’ on their loans but continue to make their monthly payments [be enabled] to earn accelerated principal reduction over time. . . .”

Why the calls for paying down the principal on the mortgages of homeowners who are underwater at this point? In broad terms, the fear is that the housing market is overcorrecting. Housing prices are at a point where they are widely affordable and are close to where they should be based on long-term trends. Already homeowners have lost more than $6 trillion in equity in their homes, yet home prices continue to fall—and seem likely to overshoot the correction that was needed back in 2007. As a result, homeowners are actually more heavily levered now than they were in 2007 due to the 30 percent fall in home values. (See the chart below, prepared by the Federal Reserve Bank of New York.)

McIlwainMortgage_1_500

The continued fall in home prices is resulting in more underwater homes—which is stalling the normal functioning of the housing resale markets, keeping people from selling their homes so they can move to jobs, and continuing to push more homes into foreclosure. In other words, a vicious cycle has been created that—in the minds of a growing number of conservative and liberal thinkers—can be broken only by bailing out underwater homeowners.

The politics of any proposal along these lines is, to say the least, difficult. Understandably, taxpayers who were prudent and whose homes are not underwater may resent their tax dollars going to help those who now find themselves underwater, many of whom foolishly overleveraged their homes (and many of whom did not but were caught in the downdraft of housing values anyway). The issue of moral hazard also is a real concern. There is also the view held by some that the markets should just be allowed to correct themselves without the intervention of the government.

Important as these concerns are, the fact that the ongoing collapse of the housing markets is holding back the overall economic recovery should bear greater weight. And the cost of a write-off program would be less than the cost of allowing the markets to clear on their own for two reasons. First, less is lost when a loan is written down than when it is allowed to go into foreclosure in today’s weak markets. Second, it is possible for the government or lender to share in any subsequent price appreciation of the property in order to offset the original cost of paying down the mortgage; this also moderates any moral hazard.

From a purely political point of view, it could be argued that as the federal government bailed out the banks and the auto industry in order to get the economy moving again, why not bail out Mom and Pop if that is what is needed now? This at least might be the perspective of many in the Tea Party and the Occupy movements, the latter of which is just now turning its focus to foreclosures.

What would a program of principal reduction entail and could it be done comprehensively? There are now estimated to be between 11 million and 14 million underwater homes—roughly 25 percent of all homes with mortgages. While there are some in every state, they are heavily concentrated in California, Nevada, Arizona, Michigan, Florida, and Georgia. A study released by CoreLogic earlier this year estimates the total amount of negative equity to be in the range of $750 billion. Both the number of loans underwater and the total amount of this negative equity make the task of writing down these mortgages daunting.

The administration, however, controls some 80 percent of all outstanding mortgages through the Federal Housing Administration (FHA), Fannie Mae, and Freddie Mac. This suggests that it has the ability to begin a process that in time could result in the writedown of a large portion of underwater mortgages. For instance, the administration could start by having the FHA, over which it has the most unfettered control, create a process to identify these mortgages and write them down to an appropriate balance.

For it to instruct Fannie Mae and Freddie Mac to do the same would require the agreement of the Federal Housing Finance Agency (FHFA); to date, the FHFA has been reluctant to engage in principal reductions. A successful program at the FHA and growing pressure from both conservatives and liberals, however, might begin to change the views at the FHFA. The final 20 percent of mortgages is held by banks in their portfolios or in uninsured mortgage pools; these would likely be the most difficult to write down. That said, beginning a program that covers a large majority of underwater mortgages could go a long way toward stabilizing housing markets.

Unfortunately, the likelihood of such a program beginning during an election year is problematic, which means that the country will continue to drift through the housing recession for at least another year. What is becoming clear, however, is that some form of bold action is required to break the current vicious cycle of falling values, increasing numbers of underwater homes, foreclosures, and stalled demand. Whether or not writing down hundreds of billions of dollars’ worth of mortgage debt for U.S. homeowners is the best way to revive the economy and the housing markets, action on a scale well beyond anything proposed to date by Congress or the administration is needed to avoid years of ongoing stagnation.