Demanding that Homeowners Make Good on Underwater Mortgages Is the Height of Moral Hypocrisy

The Feds, the mortgage bankers, commercial banks and investors in mortgage-backed securities conspired to let people buy homes with little or no money down. One's choice of villains in the saga that ensued is based on where one sits in the political wars. Investment bankers. Mortgage bankers. Standard & Poor's. Barney Frank. Chris Dodd. Frank Raines. Alan Greenspan. Whatever.

But now, faced with a cascading foreclosure problem, homeowners -- a questionable notion for owners of a property with zero equity -- are being told that the moral and ethical thing to do is to stay in their homes, and make good on "their" obligations. After decades of watching Donald Trump put various casino or hotel businesses into bankruptcy when a deal turned bad, and then go back to the same banks for another bite at the apple, American owners of bankrupt -- debt exceeds asset value -- properties are being asked to stay the course, to "do the right thing."

This, of course, is the Paulson Doctrine. On March 3, 2008, two weeks before the collapse of Bear Stearns, the Treasury Secretary set forth the principle that -- unlike Mr. Trump -- homeowners should stay the course:

Homeowners who can afford their payments and don't have to move, can choose to stay in their house. And let me emphasize, any homeowner who can afford his mortgage payment but chooses to walk away from an underwater property is simply a speculator - and one who is not honoring his obligations.

Today, the Paulson Doctrine has been embraced from the president on down as the responsible course of action. For an increasingly diverse America, this is the new Protestant Ethic. Forget Donald Trump, celebrated for a decade as the face of the American economy. Forget that the banks that made all those loans -- time and time again -- to Donald Trump's businesses, have had those and so many other bad beds paid off by the American taxpayers.

There is no greater irony than the continuing spectacle of American taxpayers -- the yet-to-be-born grandchildren of American taxpayers actually -- who once thought that they had secured their piece of the American Dream, are now being told by the very bankers who they have bailed out that their moral and ethical obligation is to stay the course.

Thirty years ago, in the first day of the class "Financial Markets and Disintermediation" at the Wharton School, Professor Smith began by musing that each of the world's great religions decry the impact of debt on the individuals and society, and are derisive of bankers and banking activities. His words were lost on the gaggle of aspiring investment bankers, who aspired to follow in the footsteps of Michael Milken and Donald Trump rather than consider WWJD.

The Koran is enlightening on the subject of debt. The principles of sharia lending suggest that debt creates an undue power relationship between the lender and the borrower, and accordingly it suggests that there should be elements of risk-sharing in lending activities. While referencing the Koran in any regard may make one suspect in American discourse today, the notion of risk-sharing in financial arrangements, and in particular in financial arrangements where the power relationship is totally skewed toward the lender, as in the world of consumer and mortgage banking, is worth considering.

While Professor Smith was reflecting on moral considerations, across the hall Professor Percival was articulating the Miller Modigliani Capital Asset Pricing Model, a central tenet of the Wharton finance program. In simple terms, this model, based on the theoretical work of Nobel laureate economists Franco Modigliani and Merton Miller, demonstrated that you cannot increase the value of a business by increasing the level of debt -- the approach for which Wharton grads led by Michael Milken would become famous over the ensuing decade -- unless debt receives favorable treatment under the tax code relative to equity.

If the last paragraph made no sense, don't worry. The point is that we are in the process of unwinding a massive debt crisis that has laid bare a number of fundamental flaws with our financial system, inequities in our legal system, and corruption of our political system. And a central cause of the over-leveraging is that our tax code gives everyone incentives to "lever up."

It is easy to point out the moral hypocrisy of demanding "homeowner responsibility" in a society that for years has celebrated business icons that eschew such practices. However, it will be harder to acknowledge how -- much less garner the political will to change -- the rules and practices that directly contributed to the financial crisis. Democrats will decry ending the tax deductibility of mortgage interest that appears to make homeownership more affordable. Even more difficult will be changes that provide balanced treatment of debt and equity. But if we are to build a more resilient economy and address the very real problems of over-leveraging, we have to consider the extent to which the crisis that emerged was a direct consequence of the incentives that the tax code created.