Debt Reduction

John Geanakoplos and Susan Koniak have a nice op-ed in the New York Times that proposes a solution to the mortgage crisis. The key point is to focus on reducing principal rather than interest rates on mortgages where the borrower is underwater. Some great pictures in the article on how default rates are related to the extent a borrower is underwater.

The key point, I think, is that when you have a borrower who is insolvent you solve the problem with renegotiating the principal, not reducing the interest cost. The latter may deal with liquidity, but not insolvency. For the latter you need to make the borrower have an incentive to pay off the loan. That is where principal reduction comes in. They also show what their solution is cheaper than those considered by the Obama administration.