The housing statistics are staggering. Over the past five years, the 30% average drop in prices has cost homeowners approximately $7 trillion in wealth. More importantly, according to data from CoreLogic, over 11 million homes are now underwater, representing nearly one-quarter of all mortgages. Close to one-half of all homes are either underwater or have equity positions of less than 20% of their current home value. Beside the obvious loss of wealth, this contraction in home equity values has frozen the housing market and introduced a large structural impediment to the country's natural ability to reallocate labor from high unemployment regions to more prosperous areas of the country.

To see how the contraction in home prices has compounded the country's economic problems, consider a homeowner living in a high unemployment region with a home price now at or below the outstanding mortgage balance. Perhaps, the homeowner would like to move to a region with better job prospects, North Dakota comes to mind, but to do so would require either abandoning his house or agreeing to a short sale. Either way, the homeowner ends up with no equity and possibly a weakened credit record. Purchasing a new home will be out of the question since he has lost his equity for a down payment, and even renting may be difficult depending on his credit position. The result is that the homeowner is frozen and the country loses its dynamic ability to reallocate resources.  Whereas in Europe people do not readily move from high to low unemployment regions because of cultural and political impediments, Americans are now frozen because of personal wealth considerations.

The mortgage situation affects more than just people looking to move to regions with better job prospects. It also affects growing families looking to upsize their residences as well as empty nesters and elderly looking to downsize. After selling their current homes and recovering what if any remaining equity, even families with stable jobs and solid income streams likely now lack the requisite down payment necessary for their move. The result is that these families do not move, contributing to the frozen market and fostering an inefficient allocation of resources.

There is a simple solution to this problem and, in fact, it already exists in certain securitized obligations and is in limited use in private commercial real estate transactions. The answer is to convert outstanding as well as new mortgages to a collateral substitution mortgage. Specifically, homeowners should be allowed to substitute housing collateral of the equal or greater value without requiring the payoff of the original mortgage loans. Valuation of the existing and proposed home collateral would be based on independent appraisers acceptable to the mortgage originator or processor for outstanding loans. A form of this product, called a portable mortgage, was briefly offered by E-Trade back in 2003.

Let's see how this might work. Consider a homeowner that purchased a house for $300,000 with a $270,000 mortgage. Because of the decline in housing prices, the home is now worth $250,000. A homeowner wants to move to a region with better job prospects and finds a house also worth $250,000. However, it is impossible for the homeowner to move since he has no equity to use as down payment for the new home. But, using collateral substitution, the homeowner would sell his home and use the proceeds to buy the new home which would then secure the current outstanding mortgage. The lender is no worse off, and is likely in a better position if the homeowner has moved to improve his job prospects.

Or assume a homeowner wants to purchase a $260,000 home and has saved the additional $10,000 necessary for the purchase. The homeowner would use the $250,000 sale proceeds along with the extra $10,000 to purchase the new home and the new home would be substituted as security on the outstanding loan. The bank ends up in an improved situation since there is now a $260,000 property securing the mortgage, an increase in collateral value of $10,000. Without this process, the homeowner would not have been able to make the move since, even with a short sale, he would only have had $10,000 as down payment for the new home, well below currently required levels.

This process would also help those downsizing. Again, consider a homeowner looking to downsize to a $200,000 home. If the homeowner sells his current home he would recover no equity and may not have savings available for the new down payment. But, by allowing the homeowner to use part of the sales proceeds to pay down $50,000 of the mortgage balance and then substitute the new home collateral, both the homeowner and lender would be in a better position.

There also are long-term benefits to new homebuyers. Using a collateral substitution mortgage would allow borrowers to lock in the very low current long-term mortgage rates and continue to keep these mortgages outstanding as they move to subsequent properties.  This feature provides an incentive to choose fixed rather than adjustable rate financing which should have a stabilizing effect on homeowner wealth as the economy recovers and rates rise to more natural levels.