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Lindley Estes is a business writer for The Free Lance-Star and This blog is on Fredericksburg-area business. Send an e-mail to Lindley Estes.

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We know what the problem is, but how do we fix it?

THERE’S widespread agreement that housing is the root of the nation’s financial problems. But disagreement on what to do about it is just as widespread.

The bursting of the housing bubble has created much of the turmoil that has felled some of the country’s supposedly strongest companies–AIG, Wachovia, Lehman Brothers, Bear Stearns and more–and crippled numerous others.

Despite efforts by the Treasury Department and Federal Reserve, housing prices continue to fall. Prospective home buyers struggle to get loans, and new home construction has ground to a halt, hurting builders and their suppliers.

Rising unemployment threatens the ability of some home buyers to make their payments. Falling prices mean other homeowners owe more on their house than it’s worth, and some are walking away. Rising foreclosures have the potential to further decrease prices, which in turn leads to more turmoil on Wall Street.

So how to stop the downward spiral? The Bush administration has focused its efforts on injecting capital into the banks to encourage lending. The administration has also prodded banks to renegotiate mortgage terms with borrowers to keep more people in their homes.

Critics say this is woefully inadequate and argue that the government must agree to lower the amount of principal held on millions of mortgages. That is the only way to stop the downward spiral, they argue. President-elect Barack Obama has made clear that he supports this school of thought.

It’s easy to see why no agreement has been reached, because in reality, both solutions are objectionable.

Banks aren’t exactly in the mood to lend out freely so more people can buy homes. That’s what created this mess. They don’t want to lower principal balances and create more losses for themselves. But the continued downward spiral of prices isn’t good for anyone, banks included.

On the other hand, homeowners who have made all their mortgage payments–perhaps sacrificing other things in their lives to do so–are not going to be thrilled if less-responsible neighbors are bailed out of loans they never should have taken out.

So what to do? Allow the free market to work, potentially hurtling the economy into a deeper malaise? Or stop the flow of foreclosures by rewarding those who have fallen behind while doing nothing for those who have kept up with payments?

One of the more innovative solutions I’ve seen came in a Wall Street Journal op-ed this past week by Martin Feldstein, an economics professor at Harvard University and former economic adviser to President Ronald Reagan.

Feldstein writes that the U.S. is "virtually unique" in allowing homeowners to walk away from mortgages without putting any of their other assets or future wages in jeopardy. Other countries don’t have these "no-recourse" mortgage loans, so homeowners elsewhere aren’t as likely to walk away from their home if its value falls below the mortgage.

Feldstein writes that more than 12 million U.S. homeowners now have mortgage debt that exceeds the value of their homes. He proposes that these homeowners have their mortgages restructured into full-recourse loans, which allow lenders to take assets of the borrower if repayment is not made. He proposes that the government take part of the loss, and the lender takes the rest. Here’s his example:

A homeowner has a $240,000 mortgage on a home worth $200,000. The $40,000 gap (which is the average negative-equity gap) is split between the government, which takes a third, and the lender, which takes the rest. The $200,000 mortgage would be converted to a full-recourse loan.

All three parties would share some pain. The government would lose $13,000 per house (Feldstein says with 12 million negative-equity homes, taxpayers would spend $156 billion under that plan). The lender would potentially lose $27,000 per house. And the borrower would have much more riding on the loan.

But everybody would benefit also. The government could help keep more people in their homes, which would accelerate a recovery in housing. The lender would have a more secure loan and protect itself against future losses. And the homeowner would have reduced principal and the ability to stay in the house.

Sounds like a pretty good solution. We’ll see if the government is able to come up with something similar.