Uncreative Destruction

Why is the nation that came up with the iPod, Prozac and La-Z-Boy so unimaginative when it comes to its biggest product of all--home mortgages?

Halfway through a rather predictable speech before Congress on housing woes in September, Federal Reserve Chairman Ben S. Bernanke suggested something radical for the mortgage industry: Why not show a little creativity in financing home purchases?

He's got a point. It's just possible that variations on the standard 30-year home mortgage might have facilitated homeownership without precipitating the collapse in subprime lending that is now killing borrowers and lenders alike.

Recent years have, to be sure, seen some novelties in mortgages--letting buyers pay interest only, for example, or giving them low teaser rates to start out--but the new terms served more to foment speculation and risk-taking than to dampen it. What if, instead, buyers had been given ways to reduce risk, just as they can easily do with their stock portfolios? Then they would have sacrificed some of the gains in a bull market, but they would have been better equipped to survive the housing bear market.

"The U.S. has been creative in mortgages but only in a very narrow way," says New York University professor Andrew Caplin. "[We have] lost ambition for the large ideas."

Here are five ways banks could reduce the risk of foreclosures.

Share the appreciation. In return for a payment from an investor, the homeowner agrees to share the profit on the home if and when he sells at a profit. This is like buying some stock and then reducing your risk in it by selling call options against your position. The payment could go into an escrow to be tapped in an emergency.

Hedge with a short sale. The idea is that after buying, the homeowner would short a regional index of home prices of the sort traded on the Chicago Mercantile Exchange (nyse: CME - news - people ). If the bank held the futures position in escrow, it could reduce its risk of losing money on a foreclosure; presumably, if the homeowner had to sell in a downturn, he'd make enough on the short sale to cover the decline in his home's value.

Offer puts. The homeowner buys insurance against a decline in regional home prices. In effect, he's buying a put option. The risk reduction is similar to that for the futures short sale. A nonprofit called NeighborWorks America has sold dozens of insurance policies on home-price drops in Syracuse, N.Y., but the idea hasn't caught on elsewhere.

Vary duration, not monthly payment. The risk with an adjustable-rate mortgage is that the monthly payment can shoot way up when it resets. Why not keep payments fixed but translate a higher interest rate into a longer term for the mortgage? Adjustable-length mortgages apparently aren't offered in the U.S.

Make TIP-like mortgages. Treasury inflation-protected bonds have each coupon and the principal tied to the Consumer Price Index. A mortgage version, as proposed by the late Nobel economist Franco Modigliani, would have monthly payments that creep up slowly even in times of tumultuous increases in the inflation rate (and therefore interest rates). Modigliani mortgages never caught on, and in some places (New York, for example), they are prohibited.

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