Cut Mortgage Deduction: Fed President

BIG SKY, Mont. (TheStreet) -- Saying that the United States tax code "encourages household leverage and bank leverage, even though both are potentially destabilizing," the president of the Federal Reserve Bank of Minneapolis said Monday that it is time to reconsider the residential mortgage interest tax deduction enjoyed by millions of homeowners.

Minneapolis Federal Reserve President Narayana Kocherlakota thinks mortgage-related tax deductions may need to go.

Speaking at the Tri-State Bankers Summit at Big Sky, Mont. on Monday, Minneapolis Fed President Narayana Kocherlakota said that "household and financial institution leverage exacerbate the sensitivity of the financial system to declines in land prices and so reduce financial stability."

Kocherlakota added that "the U.S. tax system promotes leverage on the part of households and financial institutions."

For home mortgage borrowers, the leverage is promoted through the deduction of interest paid on a home mortgage from taxable income. For a bank raising money, borrowing is often a cheaper alternative than raising capital through a share offering, since "the bank can deduct its interest payments from its earnings before paying any corporate income taxes."

According to Kocherlakota, "the tax code includes what is known as a corporate debt tax shield that encourages higher leverage for financial institutions."

In order to reduce the tax incentives for both forms of leverage, Kocherlakota suggests two changes to the U.S. tax code. The first is to "lower the fraction of mortgage interest that households can deduct from their taxable incomes." To lower the tax incentive for large companies to increase their leverage, Kocherlakota's second proposal is "to lower the fraction of their interest payments that corporations are allowed to deduct from their taxable incomes."

He added that "of course, it would be appropriate and important to adjust the timing of these changes in light of prevailing macroeconomic conditions.

Those "prevailing macroeconomic conditions" include large increases in the amount of capital banks will need to hold under Basel III, especially under the new guidelines for additional capital requirements for the largest banks, thus giving them a strong incentive to reduce leverage.

The current economic conditions also include huge levels of homes going through the process of foreclosure, and a serious discussion of chipping-away at home mortgage interest deductions could have a chilling effect on the thought processes of borrowers agonizing over whether or not to walk away from their homes.