Despite the heavily lobbied narrative that housing is in the midst of a recovery, the reality is far more stark. New-home and existing-home sales fell last month, and what stability we’re seeing on prices comes in large part from a massive shadow REO that isn’t sustainable. Mortgage delinquencies actually rose in June. And you have 11 million underwater homeowners who are sitting ducks to fall into delinquency, with one financial shock potentially putting them into that category. What’s more, many of them are unable to take advantage of low mortgage rates for refinancing.

The Administration’s efforts on this front have been sadly lacking. But Senator Jeff Merkley is out with a plan that should have been adopted years ago, when it would have had a broader impact and possibly stopped some of the 4 million foreclosures we’ve seen in the last 4-odd years. While not a panacea – this again goes after the 8 million or so underwater homes that are current, where borrowers are making the payments – it would provide security for them, get the loans out of the hands of the banks, increase purchasing power, construction and consumer spending, and even turn a profit for the government.

Here’s how it works. Every underwater homeowner, under this plan, could go to any loan origination center and refinance their loan into one of three options, which I’ll detail later. That loan would then get sold to a one-time vehicle modeled on the Home Owner’s Loan Corporation from the Depression era. The vehicle, which Merkley calls the Rebuilding American Homeownership Trust or RAH, could be housed in the FHA, the Federal Home Loan Banks or the Federal Reserve. It would be an available option for three years, and would only manage and service the loans it purchases under that time, going out of business once all the loans are completed. The RAH Trust would use Treasury-like bonds to generate capital from private investment, purchasing at the current low cost-of-funds rate of 2% on 15-year debt and 3% on 30-year debt. Then it would lend out at 4-5%, using the money gained on the spread between the cost of funds and the interest charged to cover any defaults (there are also some other insurance fees and bank fees to cover that spread). Merkley’s team includes several levels of analysis in the presentation piece showing that the RAH would turn a profit, and it’s not hard to see how; it basically uses the model of traditional banking to cover its losses and still offer a low finance rate to borrowers, saving them hundreds of dollars a month.

I would rather it didn’t have to guarantee a profit at all, and that it could offer the lowest rate possible. I refinanced into a 15-year loan last year at 3.25% and rates are lower now. The lowest rate Merkley’s plan offers on a 15-year loan is 4%. “We sought to design something that has a chance of actually happening,” Merkley said in an interview yesterday. He said that the limited nature of the single-purpose vehicle appeals to his colleagues, as well as the use of private investment (albeit with a government guarantee like a Treasury bond) to acquire the capital, so taxpayer money isn’t at risk. Finally, Merkley said, “This gets rid of the arguments about moral hazard. Instead of choosing winners and losers, who gets a modification and who doesn’t, this says that everyone can apply under the same terms.”

Those terms are open to any underwater borrower, even the severely underwater folks. In circumstances where the borrower has over a 140% loan to value ratio, the bank would have to write down the loan to that level in order for the RAH Trust to purchase the loan. Merkley said his discussions with bank executives convinced him that they would leap at the chance to sell off deeply underwater loan with that kind of a haircut. Now this presents a significant risk on the trust, even at 140% LTV. But that’s why the spread is there, to cushion the blow of a potential default. Banks would also pay a risk transfer fee, a small fee to help cover the spread. “They’ve said to me, if it’s a modest haircut, it’s a reasonable business proposition, and they will participate,” Merkley said.

Borrowers would have three options on the loan products: a 15-year loan at 4%, which would charge about the same monthly payment they’ve been making but would recapture equity much faster; a 30-year loan at 5%, which if they’re locked in a high-interest product could save them between $500-$800 a month; and a two-part mortgage, with a 30-year loan (with a 5% interest rate) at 95% of the home’s value and a soft second loan, which would not accrue interest or require payments for the first five years. This forbearance option would lower the monthly payment even more. So this has a flexible range of options for the borrower, whether they are doing fine with their current payment but want to build equity, or whether they are struggling and need relief.

Merkley said that this idea is desperately needed, because even with improving refinance activity, we still have 11 million underwater borrowers, and only 170,000 have gotten a loan through the government’s refinancing option, HARP. And HARP itself is limited on underwater borrowers to loans owned by Fannie Mae or Freddie Mac. This plan does not rely on banks to make decisions on who gets a refi, opens it up for nearly universal participation, and could hold off that second wave of foreclosures, which are often determined by who’s underwater. It also represents a fair deal for investors, who would get ripped off by the other plan floating out there, using eminent domain to seize mortgages and refinance them, and would be likely to litigate, ruining the effectiveness of that idea. This could also kickstart the housing market by resetting some of the most troublesome loans, and put hundreds of dollars a month into the pockets of millions of people. “You not only help housing-specific industries but the broader economy by adding to the purchasing power of these families,” Merkley said.

But this is still a limited program. It does nothing for those who are currently delinquent, a number which stands at 5.6 million and rising. It doesn’t stop our current foreclosure crisis. It does a good job for those borrowers who survive it, but those who most need help right now don’t get it from this plan. Merkley went back to the need to design a program that actually has a chance of happening. If his plan went into place at the outset of the crisis, it would have saved a lot more of those delinquent and foreclosed borrowers. Merkley added that those borrowers “are being addressed” by programs he admits are faulty, like HAMP and the FHA short-refi program. If you incorporated the delinquent into this RAH program, you would have to increase the interest rate to cover the default spread, and at that point it becomes unhelpful in terms of lowering monthly payments.

Merkley’s vision is to get pilot programs for RAH operating in several states between now and the end of the year. He believes the government can do this on a pilot level without Congressional action. The Administration can use funds that are going to waste under their other housing programs. A report yesterday showed that 90% of housing-relief programs under TARP have gone unspent. In particular, Merkley singled out state Hardest Hit Funds, which they control, or even funds from the mortgage settlement as a vehicle to set up the pilot program initially.

A larger program may or may not need legislation (to allow for the bond purchases to fund the program) and would certainly need Administration input. One method would be to use the Federal Reserve to purchase the mortgages and create the trust. The Fed is already considering purchasing mortgage-backed securities in mass quantities, this would just take them the rest of the way there. In this fashion, the Fed could solve the problem they’ve been having, of getting their low interest rates into the hands of people who need them. “This would inject monetary policy into the heart of the economy,” Merkley said. He has met with Fed governors who he described as intrigued by the plan, but who also told him the odds of adoption were slim. That’s where the pilot programs come in, to build momentum and prove the concept, and break down the walls of skepticism.

More on the plan from Matt Yglesias and Felix Salmon. While limited in scope, it’s a bigger plan than anything else out there. And it does it the right way, by not relying on banks, creating an HOLC-type option inside the government, and a satisfying solution for everyone involved.