The Economist The Obama Administration Should Have Listened To

Eight months ago, the Obama administration launched a plan to help troubled homeowners avoid foreclosure by providing $75 billion in taxpayer funds to banks and mortgage servicers. The money was intended to help millions of homeowners by lowering their monthly payments, largely by cutting their interest rates.

The next day, a Yale economist and a colleague penned a New York Times op-ed arguing for a different approach.

Rather than cut interest rates, John D. Geanakoplos and Susan P. Koniak wrote, the government should reduce the overall amount owed on the mortgage -- the principal.

Mr. Geanakoplos was absolutely right, even though it's not too late for the Obama Administration to correct the problem or force the lenders who created this mess to comply. Cutting interest rates without reducing principal now seem to be a bad move for homeowners who owe more than their properties are worth.

"The plan announced by the White House will not stop foreclosures because it concentrates on reducing interest payments, not reducing principal for those who owe more than their homes are worth. The plan wastes taxpayer money and won't fix the problem," they wrote.

Only five of the 1,711 permanent modifications as of Sept. 1 involved a principal reduction -- in fact, most homeowners with a permanent fix ended up owing even more on their mortgage than they did before the modification.

For those who were already "underwater" on their mortgages, meaning they owed more on their mortgage than the house is worth, the move pushed them even further below the surface.

Geanakoplos, interviewed on Wednesday by the Huffington Post, says the best thing to do now, "To help people with negative equity, the subsidies in the Obama plan should be redeployed so that they are used to modify loans by reducing the principal balance." The Administration should come up with a new idea that the reduced principal would be less than the value of the house - so the homeowners would have equity again.

The net result would be that the homeowners, with newfound equity, would have increased motivation to stay in their homes, and the bondholders would be satisfied because they would maintain their income stream and wouldn't lose as much money as they would through foreclosure.