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A Different Solution To Solving The Housing Crisis

Seeking Alpha has many articles on the failures of the government’s plan to address the housing crisis, but few offer any solution. This article outlines a better way to address the housing crisis, and not surprisingly, it is by letting the market work.
The government has thus far employed the Neville Chamberlain approach to economics: “we have jobs in our time”.  An $8,000 tax credit will stimulate demand this year, but mostly by pushing demand forward from 2010 and 2011. Low interest rates do not help housing unless you lower the risk inherent in the loan. Lowering the cost of risk or giving people $8,000 tax credits is welfare. It simply shifts demand from the future to the present, and from non-housing goods to housing.  
The downside to the government's effort is, of course, that we will get to the future at which point slack demand will prolong the recession.  We have not only pushed demand from the future into housing, but we have shifted it away from productive sectors.  The net effect is to encourage people to build houses that no one wants, nor can afford. So government’s solution is in short: fix housing by breaking everything else.
Unlike the government’s approach, this solution actually changes the dynamics of housing. It lowers the likelihood of future foreclosures even if asset values continue to fall. It is a series of incentives which get people to refinance their loans with additional capital. This is materially different than what the government is doing because the refi’s under the current program require neither additional financial or human capital.  (Human capital is the upkeep you do on your house). 
Here is the consequence. There is a home in Michigan the mortgage on which is about 25% underwater. The owner likes the place enough to keep the mortgage current. But in the back of his mind, he knows that it is likely that this house is going into foreclosure, so he invests zero into the house beyond the monthly mortgage.   In his mind, he no longer owns the home, but is simply renting it from the bank. He treats the house like rental property.
Incentives can take many forms, but I will illustrate one as an example.  Currently people are not allowed to take a tax loss on a primary residence. The government could enable people who refinance an upside-down mortgage with additional capital to take a tax loss based on the amount of the capital that they add to the loan.  No one would dispute that paying say $10,000 into a loan that is $25,000 underwater is a tax loss. No sensible lender on a non-recourse loan would refuse to accept said money to refinance the loan.
Here is why this approach is better than what the government is doing. The market knows more about loan quality than the government does. The government’s approach is unfocused, wasting billions of dollars on loans that no one intends to repay as demonstrated by the default rate on loan modifications (more than 50%). People will only put more money into a loan that they plan to pay-off. So the market will direct the incentives to loans which the borrower at least thinks are good.
This transaction isn’t for everyone, and really is meant to show the consequences of the incentive. The guy in MI would take this deal because he doesn’t want to be a renter. More important than increasing the loan quality, this approach gives him an incentive to invest human capital in the house, if nothing more than raking up leaves.   He happens to be rather handy with tools, and is more than willing to work on the house provided that the he shares in the benefit of the work. At this point, however, all of his work goes to the bank because that house is heading for foreclosure when he gets tired of paying so much in rent.
Again, this is just an example, here are the factors that you want to see in any incentive :
1)      Verifiable : In the case above, the mortgage lender will get a check for additional principal.
2)      Tied To Existing Housing : We do not want to encourage people to build more houses
3)      Focused: The government may create the incentive, but the market must allocate it for it to work. 

Disclosure : I pay taxes