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It seems like lenders would potentially be able to take a pretty huge loss if the principle could tank 80% in a housing crash.
Wouldn't that have rather severe downstream implications?
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They were already taking huge writedowns anyway, due to the homes being underwater and the mortgages not being repaid / entering foreclosure.
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True. Do you think it would more or less be a wash?
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The thesis itself is pretty straightforward. What if the predominant type of mortgage had been a shared appreciation mortgage (SAM)---mortgages whose balance is indexed to the price of the home?
The motivation was that the GFC precipitated by foreclosures, which generally require two things to be true: 1. inability/unwillingness to pay, and 2. underwater on the loan. If borrowers weren't underwater, there wouldn't be as many value-destroying foreclosures.
What if the mortgages had been indexed to house prices? Then, house prices going down wouldn't trigger the underwater condition and there wouldn't have been a wave of foreclosures. Moreover, when house prices were expected to appreciate, the lender can make the SAM at very favorable terms because they expect to receive some of that appreciation. Many borrowers who are liquidity constrained would presumably be willing to trade some of the house price upside for more favorable terms upfront, like lower payments or lower LTV requirements.
The paper built a quantitative model to simulate outcomes had this been the case and do welfare calculations.