With home prices aggressively dropping a big concern amongst some investors holding mortgage backed securities is that some of the houses will be worth less than what the mortgage borrower owes. Explained by Nouriel Roubinin in his congressional testimony [PDF]:

In most US states mortgages are a non-recourse loan; thus, if a home owner defaults on its mortgage the bank take over the collateral – the home – via foreclosure but once that happens it cannot go after the borrower for any difference between the value of the original mortgage and the current value of the property.

Some home owners may get out of their mortgages simply by missing payments and mailing their house keys to the bank, a process that is known as jingle mail. It will damage their credit scores, but if they can’t keep up with the mortgage then those were going to get damaged anyway.

To mitigate the risk of homeowners walking away, the Office of Thrift Supervision is in the early stages of a plan to create negative equity certificates:

Under the regulatory agency’s proposal, still in its early stages, these borrowers would refinance into government-insured loans that cover the current value of their homes. The refinancing would pay part of what’s owed to the original lender. For the remainder, the lender would get what the plan’s backers call a “negative equity certificate.” The lender could redeem the certificate if the home is eventually sold at a higher price.

Hundreds of readers of the influential Calculated Risk blog are doubtful of the viability of such a program, as guessing a bottom in home prices is aiming at a moving target, especially with so many homeowners having zero equity or negative equity.

To appreciate how ugly the problem is, here are a couple charts. Click on either for a larger view.