I caught a few moments of a Ben Bernake Speech while I was walking out the door, he was discussing defaults and delinquency issues and the issue that many homeowners face of negative equity. The major question he was raising is what can be done about negative equity issues? So far banks have been very willing to grant homeowners in these situations interest rate drops, but they have been rather unwilling to drop principal. If I would have been able to finish the speech his tone was sounding as if he was suggesting that principal reductions and interest rate reductions may need to be used more aggressively in order to help homeowners in these situations.
Negative equity is an issue that is likely to affect many homeowners who bought in locations where home values reached overinflated levels of a few years ago.(i.e. California, Saint George UT, and Las Vegas NV)The solution to these problems are difficult, banks that simply forgive principal may find in a few years (if and when values rebound) that they have thrown significant investments away, and homeowners who were unlucky enough to have fallen into these traps find refinancing very difficult and selling without near catastrophic results impossible as well. Bernake seemed to be advocating for banks to reduce principal where needed to allow sub prime mortgage holders to refinance into a manageable loan.
Another idea which I thought about would be a "qualified" principal reduction, reduce principal currently based on a appraisal so the mortgage can be refinanced. After 5 years or so another appraisal would be required, and if the home's value has rebounded than the forgiven principal would be added back to the loan. If home values haven't rebounded than the forgiven principal would remain forgiven. The tax-ability of the forgiven principal should be suspended until the 5-year appraisal. There really is no easy answer to this problem other than to learn from what has happened and make necessary reforms. I believe the mortgage meltdown will likely turn into the mortgage industry's Enron, Enron gave the accounting industry SOX regulations, and I anticipate the mortgage industry will end up with similar regulations. (FYI NY state is already headed down this path)