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In a rather disturbing trend, some banks are beginning to forgive portions of the principle owed on mortgages in arrears:

(From the WSJ):   "As home prices slide and loan defaults pile up, some mortgage companies are slashing the amount that borrowers owe, deciding that a permanent cut in the loan balance may pay off if that helps teetering borrowers avoid foreclosure.

The small but growing push sharply contrasts with most loan-modification programs. Borrowers often get a lower interest rate or years longer to pay off their mortgage. But such changes may not be enough to make the loan payment affordable and don't fix the problem of borrowers owing more than their home is worth.

Reducing the principal on mortgages is "a last resort," says Paul Koches, executive vice president at Ocwen Financial Corp., a West Palm Beach, Fla., loan servicer that has shrunk the amount owed on 10,884 delinquent mortgages as of Sept. 30. That is 23% of all the loans modified by Ocwen so far this year.

On average, such borrowers saw their loan payments drop by 20% to 40%, typically by lowering the loan balance and interest rate. Ocwen estimates that the savings for investors who own the mortgages vary from a nominal amount to more than $325,000 per loan compared with the likely return if the loans wound up in foreclosure.

Many mortgage lenders and servicers have been reluctant to drastically change loan terms, in part because of worries that would antagonize investors who own securities tied to the loans. Mortgage servicers are responsible for collecting mortgage payments and working with troubled borrowers.

Not everyone agrees reducing the loan balance is the right move. J.P. Morgan Chase & Co.'s new effort to restructure as much as $70 billion in mortgage loans doesn't include principal write-downs. Instead, J.P. Morgan will sometimes base new loan payments on a smaller loan balance, while requiring that the full loan amount be repaid when the borrower refinances or sells the home. This approach lets the bank benefit from any subsequent increase in home values, a spokesman says.

But as foreclosures mount and the economy worsens, there is "a begrudging acceptance...that this is the way things have to move," says Sharon Greenberg, a mortgage strategist with Barclays Capital, a unit of Barclays PLC."

Graphic courtesy of the WSJ

In other words we're heading towards a situation where it's likely that a large number of borrowers are going to have their debt forgiven en masse, and it's probably only a matter of time before previously rejected proposals to begin forgiving credit card debt catch hold.

All of this begs the question: if we have a crisis that was caused by irresponsibility on the part of both borrowers, regulators and lenders, what happens when you start effectively rewarding many of these same people for their misdeeds and punishing those who behaved responsibly?

I understand that in extreme times extreme measures are needed, but I just can't support anything that rewards the irresponsible and doesn't punish those who need to be bailed out.

In any case, if idea of debt forgiveness continues to take hold don't be surprised if America's debt addiction subsides for only a short time period before it comes back stronger than ever.

Mind you I understand that debt forgiveness may very well turn into a necessary evil, but there should be some sort of penalty imposed on those who receive it, and/or the banks should only do it on the condition that they get a piece of the action if the value of the home recovers.

You can read more here.

Sources

The WSJ: "New Tact in Default Battle: Cutting Mortgage Principle" -- Ruth Simon, November 20, 2008.

Disclosure: at the time of publishing the author didn't own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn't be viewed as financial or investment advice.

Source: Banks Forgiving Mortgage Principle: Reward for Bad Behavior?