It is a tempting solution to the current problem: for those whose mortgage balance is greater than their house value, cram down the loan owed to the value of the house. This will presumably reduce the probability of default substantially, and losses will (largely) be borne by those who took on the lending risk. Ben Bernanke likes the idea, and he knows a lot more about financial crises than I.
But two serious problems stand out. First, future investors could respond by requiring higher spreads for mortgages. If these spreads get capitalized into values, the borrowers whose loans got crammed down could find themselves under water again, and the problem will remain.
Second, there is an issue of fairness. Consider two borrowers, one of whom has a 20 percent down payment, and the second of whom has a 5 percent down payment. If house prices decline by 10 percent, the second borrower gets debt forgiveness, while the first one doesn't. Perhaps the first casualty of financial crises is fairness, but as a policy matter, it is hard to ignore the problem.
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