The administration's plan to bail out homeowners with adjustable rate mortgages (ARMs) may make them slaves of their homes. We propose an alternative that we believe better serves both homeowners and the marketplace.

The group targeted for the bailout has been able to meet their payments during the "teaser periods" when interest rates are kept artificially low. As these rates reset to market rates, many borrowers default on their payments. The bailout urges banks to help refinance such loans to stem foreclosures. On August 31, the government's Federal Housing Administration (FHA) announced a program called FHASecure that will allow borrowers with reasonably good credit histories to refinance their mortgages. To qualify for the FHASecure plan, borrowers must meet these criteria:

• a history of on-time mortgage payments before the borrower's teaser rates expired and loans reset;
• interest rates must have or will reset between June 2005 and December 2009;
• three percent cash or equity in the home;
• a sustained history of employment; and
• sufficient income to make the mortgage payment.

The government estimates this plan may help 240,000 families to keep their homes. It will not be available to millions that have already ruined their credit histories and fallen behind their payments.

In recent years, lenders have devised ever more creative ways to allow borrowers to buy homes. As a result, subprime borrowers, i.e. those with weak credit histories, purchased homes that they could not afford. The availability of such loans also helped push up home prices to unreasonable levels. The artificially low teaser rate incorporated in such loans is financed by higher rates upon expiration of the teaser rate, increasing the amount owed, and by extending the number of years over which the mortgage is to be paid down. Mortgage brokers would sell off these loans to investment banks as quickly as possible, giving them little incentive to be concerned about the creditworthiness of the borrowers. An unusually high number of mortgages issued only in 2006 are already in default, suggesting that lending standards were rather lax. At times, borrowers could not even make the 2nd installment – the first installment is due on signing the loan papers.

The government's program doesn't focus on these extreme cases, but on borrowers that can just about make the payment of the teaser rate, but not the market rate. We question whether home owners and the market as a whole are helped by subsidizing bad decision making, even if it is only for a small group. As a result of subsidies, home prices remain artificially high, making them unaffordable to new buyers.

The government offer is bad for affected homeowners. As lenders are not forgiving part of the loan, any refinancing likely requires both higher payments and longer durations for the mortgages. Borrowers will be asked to pay all they can afford. As a result, the American dream of owning a home turns into a nightmare as it consumes every available cent for decades to come. To be relieved from their nightmare, homeowners will pray for higher salaries and higher home prices. As we have discussed extensively in the past (click here for an overview), the forces of globalization will likely cause real wage growth to be sluggish for the foreseeable future. Higher home prices are also unlikely in this environment, except if the government encourages inflation. That may well be the solution the Federal Reserve (Fed) and politicians have in mind, as the consumer and government debt are weighing on economic growth.

A proper bailout must take a completely different approach and cannot be limited to "just" a quarter million homeowners. Someone who purchased a house that is too expensive to maintain is best helped by downsizing to a less expensive home. However, homeowners are often "locked into" their mortgages as the mortgages are higher than the market value of their homes. Leverage is great when home prices are rising, but is painful when prices are falling.

When a homeowner is allowed to downsize to a home that fits his or her budget, everyone will benefit in the long-term. The homeowner will, once again, be able to save, invest and spend money, have a life. Home prices will adjust to a more reasonable level, making them affordable for new buyers. Lenders will have an incentive to apply prudent underwriting (lending) standards.

There are a couple of ways a homeowner can "downsize". If one can sell the home at a price higher than the value of the mortgage, this is the most straightforward way. If selling the home may yield less than the value of the mortgage, options include "walking away", "short selling" the home or bankruptcy.

Bankruptcy may be the most strenuous option, as creditors will have a claim on all of the homeowner's assets, not just the home (this discussion is not to be construed as tax or legal advice). Recent changes in the bankruptcy code may also force the homeowner to come up with a long-term payment plan rather than writing off part of the debt.

Walking away from a mortgage means that you send the lender the keys of your home. The lender will then foreclose on your property, trying to auction it off to the highest bidder. Typically, the lender will not go after the personal assets of the homeowners. Once a homeowner has decided to walk away from a property, a lender will expect him or her to dismantle anything of value, including the kitchen sink and bath tub. Lenders may also foreclose on homeowners that have fallen behind payments, but don't want to leave their home.

Short-selling a home refers to negotiating with the lender about selling the home at less than the value of the mortgage; the lender in turn agrees to waive part of or the entire shortfall. This method may preserve the credit history of the borrower. Lenders often agree to short-selling, as foreclosure tends to be the most costly option for them.

A challenge with any debt-forgiveness is that the amount the creditor waives constitutes taxable, ordinary income. In the Administration's announcement to help borrowers, President Bush encouraged Congress to pass a law that alleviates this painful side effect.

In our assessment, the rights and obligations of borrowers and creditors ought to be balanced. A great disservice was done to American consumers when the bankruptcy code was reformed to make it more difficult to walk away from debt while not applying tighter standards on lenders. If lenders face loose regulations, borrowers ought to be allowed to declare bankruptcy to wipe off their debt. Conversely, if, but only if, lenders are held to a high standard, borrowers should be held to a high standard.

We do not favor making debt-forgiveness non-taxable as it would eliminate an important disincentive to prudent household finance management. The IRS has guidelines and leeway to reduce penalties and interest on taxes owed under certain circumstances. We would encourage amendments in either the tax code or the implementation of existing guidelines that make it easier to negotiate with the Internal Revenue Service (IRS).

While it may politically be more attractive to "help" homeowners by allowing them to stay in their homes, it will do disservice to them. Capitalism has shown to work best when painful medicine is swallowed when necessary. The American dream is not to have the bank own your house and hold you hostage. The American dream encourages risk taking and allows for failure. Millions of jobs have been lost in many industries over the years as individuals, companies and entire industries have been allowed to fail; but, net, many more jobs have been created because America's reasonably free market approach that has encouraged the creation of new jobs. Subsidy of mistakes is the wrong path, whether it is for the steel industry, the cotton industry, or home borrowers who made wrong decisions.

A true "bailout" of homeowners is one that encourages homeowners to evaluate whether they should stay in their home or to downsize. The downsizing options must be streamlined and simplified. The "short selling" option is complex; too complex for many of those who acquired exotic mortgage products to begin with. The rights and obligations when "walking away" should be streamlined, clarified and clearly communicated to the public.

Lenders will have the best incentive to pay attention to whom they are lending to when borrowers have easy access to downsizing options. Credit will still be available to subprime borrowers, but the risk will be properly priced. Home prices may adjust downward; ironically, this might make them affordable once again.

There has been a lot of talk about whether unscrupulous lenders should be held accountable. Where there was fraud, of course they should. But unscrupulous lenders are a result of bad policies. Currently, real estate brokers and mortgage brokers have no fiduciary duties as they sell houses and mortgages to consumers.

Our suggestions may be painful to swallow. Few politicians will stand up and encourage rules that may temporarily depress home prices. It is also easier to blame investment bankers for the role they played in creating the problems in the subprime sector. And the Fed is more interested in lamenting that it only regulates a small segment of the lending market than admitting that it is their own policies that created the easy money that has created the problems we face now.

Rather than adopting our suggestions, we are afraid that the easier way out will be the inflationary route. The announced bailout will not cure the market, but mostly provide lipservice to show good intentions before the 2008 elections. In our view, the Fed is more likely to fight the continued credit contraction by trying to increase money supply. As the Fed fights market forces, the dollar may be under renewed pressure and inflationary pressures may spread.

We manage the Merk Hard Currency Fund, a fund that seeks to profit from a potential decline in the dollar. To learn more about the Fund, or to subscribe to our free newsletter, please visit www.merkfund.com.