Banks don't want to set a precedent of writing down mortgage debt - although this does happen for other types of debt in bankruptcies. Banks are concerned with the problem economists' call "moral hazard". If homeowners know that debt reduction is possible, they are more likely to pay too much for houses they can't afford.
However, just lowering monthly payments may not solve the foreclosure problem. Homeowners who are underwater are less likely to keep up with mortgage payments - even if they have modified their mortgage.
If the problem of moral hazard could be solved, forgiving mortgage debt does offer banks some benefits:
(1) Banks lose lots of money when houses go into foreclosure, and the legal costs are rising. In some cases, banks would lose less money by forgiving debt than by foreclosing on a house.
(2) 25% of all mortgages are underwater so the problem can't be ignored.
(3) Foreclosures are contagious (i.e. create a negative externality). A foreclosure lowers the price of nearby houses and makes their owners more likely to foreclose.
One proposed solution to the moral hazard problem requires homeowners to give banks a share of equity in their home in exchange for debt forgiveness. Homeowners would lose some potential profit from the future sale of their home. At least one mortgage service provider (ISGN) has already introduced a Real Estate Shared Equity Transaction (RESET) program (see Housing Wire (4-9-2010) ).
It is unclear how many banks would be willing to consider swapping house debt for house equity. This swap could increase the banks' exposure to risk. It is also unclear how the house debt/equity swap would be perceived by bank regulators if it were implemented on a large scale.
Madeline Schnapp estimates it will take at least 5 years for the housing market to recover (see WSJ video below). The number of delinquent mortgages (past-due on payments) was 7 million last year, well above the typical 2 million per year.
Considering that housing accounted for 20% of GDP in 2002-2007, it will be a long time until our economy recovers. The sooner we increase production in other sectors and rely less on housing the better. Unemployed builders and real estate agents might have a different opinion - switching jobs is not easy.
WSJ (2-1-2011) Banks Boost Home-Loan Relief
WSJ Market Watch Video
Madeline Schnapp, director of macroeconomic research at TrimTabs, talks to MarketWatch's Alistair Barr about what that means for the world's largest economy.