Forgive me if I slip into some cliff metaphors for the next few posts, but the employment of the tool actually makes more sense in this context. The fact is that the expiration of the Mortgage Forgiveness Debt Relief Act, as explained by Adam Levin of Credit.com, represents a real threat to a nascent housing recovery, because it will put a deep freeze on a very large chunk of current US home sales.

In addition to treating homeowners to a gratuitous kick in the teeth, Congressional inaction on this tax provision would be a disaster. As economic momentum is kicking in, uncertainty regarding something as essential as homeownership will put a damper on consumer confidence.

Additionally, if the tax provision is allowed to expire, the market-friendly trend of banks approving short sales (nearly 340,000 of them in the year that ended in September), in which banks allow a property to be sold for less than the debt — reducing the glut of foreclosed homes, stabilizing prices, and cutting lenders’ losses — will come to a screeching halt.

Failure to extend this provision could also scuttle the hard-won $25 billion mortgage foreclosure settlement so painstakingly negotiated by the federal government — an agreement requiring banks to use the preponderance of the settlement money to help borrowers, with a minimum of $10 billion slated for principal reduction.

A world where the MFDRA expires is a world where practically no short sales go forward, where practically no debt relief gets administered, and a world with more delinquencies and foreclosure starts and less methods to dispose of the inventory. The reason that rental housing has become such a popular investment opportunity for the private equity/hedge fund crowd is that it has been easy to obtain distressed housing, through short sales for example. There’s also an expectation that the market will continue to rise that has motivated these sales, and if you kick short sales out of the conversation, that expectation will suddenly dissipate.

Sales of homes in some stage of foreclosure remain elevated, 20% of all US sales nationwide, and closer to 30-40% in the most distressed regions. Short sales of homes not in foreclosure, additionally, represented 22% of all home sales in the third quarter.

In sum, the progress in working through the backlog of inventory would come to a halt, and home sales as well as prices would suffer as a result. And housing stands as a bright spot, relatively speaking, in the recovery at this time. I don’t know if you can model the impact of the spending cuts in the sequester relative to the expiration of the Mortgage Forgiveness Debt Relief Act, but they’d be more similar than different.

We saw earlier in this depressed housing market how an expiring tax break, in that case the ill-advised first-time homebuyer’s tax credit, can distort a market still weighed down by fundamental problems. There’s no question that the looming expiration of the debt relief tax exemption has carried forward short sales in particular, and that will generate a crash if nothing gets done in the waning few weeks of the Congressional session.

Photo by Bart Hanlon under Creative Commons license.