Steven Pearlstein writes,

The Pearlstein workout process starts where things should have started in the first place — with the household income of the borrower. Using standard formulas, figure out how much they can afford to pay each month toward interest and principal on a fixed-rate, 40-year mortgage. Then, adjusting for credit score, calculate how large of a mortgage those payments can support.

I think that adjusting loan balances based on borrower characteristics is a bad idea. First, the calculations are imprecise. Second, it gives the borrower equity in the home that he does not deserve.

Instead of the Pearlstein plan, let me suggest the Kling Plan (but keep in mind that I have not put much thought into this): reduce the size of the mortgage to what it “should have been,” but calculate “should have been” based on a 20 percent down payment. Also, do the reduction as a debt-for-equity swap.

Suppose we have a single lender, and an outstanding mortgage balance of $100,000 on a home that was purchased for $100,000. The lender would reduce the size of the loan to $80,000 in exchange for 20 percent equity in the home. Down the road, if the borrower sells the house, the lender gets 20 percent of the proceeds. Meanwhile, the borrower has a lower payment and can avoid foreclosure.

In the real world, there is more than one party bearing the risk of mortgage default. For example, suppose that the lender has mortgage insurance for $10,000. How should the mortgage insurance company compensate the lender for the latter’s debt-equity swap? Two possibilities:

1. The insurer immediately pays a $10,000 claim to the lender and in return receives a 10 percent equity stake in the house.

2. Nothing happens until the house is sold. At that point, if the lender receives more than $10,000 but less than $20,000 for its equity stake in the house, the mortgage insurer is responsible for meeting the shortfall. If the lender receives less than $10,000, then the insurer is responsible for $10,000. If the lender gets more than $20,000, then the mortgage insurer is off the hook.

Suppose that instead of mortgage insurance there are two loans on the house–one for $90,000 and a second one for $10,000. Do you reduce the first loan to $80,000, eliminate the second loan, and give each lender a 10 percent equity stake? Or do you treat the second lender more like a mortgage insurer?