Nov. 17 (Bloomberg) -- The current economic crisis began in the U.S. housing market. Although the financial system seems to have been pulled back from the brink of collapse, the decline in housing prices continues to take a devastating toll, with foreclosures at a record pace in the third quarter.

Washington is beginning to turn its attention to housing, and there is progress on plans to make it easier to modify delinquent mortgages where there is a win-win solution for the borrower and the lender.

At best, though, this is only a partial solution. Many homeowners will be unable to afford any mortgage that lenders will accept. Complicated relationships between servicers and secondary-market investors will make it difficult, impossible or illegal to restructure many mortgages.

Some proposed plans exclude absentee property owners, so nothing will stop those houses from going into foreclosure. And some proportion of the modified mortgages will go into default. Evidence on the success of mortgage modification plans is incomplete, but what we know suggests that about a third of modified loans will be delinquent again in a year.

In addition to limiting the number of foreclosures, it will be critical to manage the flow of foreclosed properties onto the market. Otherwise, the mounting wave of foreclosed condos and single-family homes threatens to push housing prices far below long-term sustainable levels, inflicting unneeded pain on homeowners and the economy.

This will require coordinated action by government agencies and regulators in local housing markets. Here are some ways to facilitate an orderly unwinding of real estate:

Three Steps

(1) The borrower turns over the deed to the servicer and rents the property back from the mortgage investor for some period of time. At the end of the period, the renter can get a new mortgage from the investor at prevailing market rates if the borrower qualifies; if not, the property goes on the market.

Not only does this keep the borrower in the house and in the community, but it allows the investor to earn income from the property instead of having to dump it onto a difficult market.

(2) After a default, the investor who now owns the real estate finds a renter to occupy the property for some period of time. A portion of the rent becomes equity in the property should the renter choose to buy the house from the investor at the end of the lease.

While real-estate investors may not want to become landlords, this option also limits the flow of properties onto the market. The government might create financial incentives for investors to defer sales for specified periods of time.

Regulated Flow

(3) Set up regional clearinghouses for foreclosed properties. These would be responsible for regulating the flow of properties into local markets.

Suggestions (1) and (2) make the U.S. government and private mortgage investors landlords. This isn't something either wants to be, but it may be appropriate given the scale of the crisis.

For foreclosed properties owned by Fannie Mae, Freddie Mac, the Federal Housing Authority, or Treasury (purchased under the Troubled Assets Relief Program), these programs will be straightforward but costly in administrative staff and resources. Inducing private investors to participate will require coordinated regulation, new laws or financial incentives.

But avoiding foreclosure proceedings and delaying sales will save the investor -- whether a government agency or the private sector -- a variety of costs. A long-enough delay may enable the borrower to qualify for homeownership again or allow the local market to stabilize; at the least, it will reduce the current flood of homes onto the market.

Cheaper Route

Suggestion (3) builds on the existing property disposition infrastructure of the three main housing agencies. Treasury should coordinate efforts by the agencies to moderate the flow of real estate onto the market wherever possible. Vacant property creates costs for local governments, but the effect should be to ease housing-price depreciation.

We believe federal assistance to local governments will be cheaper for the economy and the federal budget than a continued plunge in housing prices. Private-market initiatives for cooperation among investors holding foreclosed property may work, but government-sanctioned or -organized clearinghouses are probably necessary to avoid the appearance of collusion in private voluntary efforts to unwind foreclosed property in an orderly manner.

Establishing these types of incentives and administrative programs now will help cushion the impact that millions of foreclosures have on the real estate market. While housing prices do have to fall to rational levels, it is in everyone's interest for prices not to overshoot on the downside. Preventing an unprecedented glut in properties for sale can play an important role in reducing the depth and duration of the recession.

(Simon Johnson, former chief economist at the International Monetary Fund, is a professor at MIT's Sloan School of Management and a senior fellow at the Peterson Institute for International Economics. Alex Stricker is a former director in Fannie Mae's Credit Finance Department. The opinions expressed are their own.)

To contact the authors of this column: Simon Johnson at sjohnson@mit.edu Alex Stricker at baselinescenario@gmail.com

Last Updated: November 17, 2008 00:02 EST