But secondly, and more significantly, the incentives this creates are simply awful. It effectively punishes those borrowers who have been prudent and not overstretched themselves, and rewards those who overextended themselves.

You may think this isn't the time to worry about moral hazard, but you'd be wrong – it is precisely in the actions we take (and show we are willing to take) in crises that will have repercussions for years to come that matter when it comes to moral hazard. (See Willem Buiter's excellent post on the matter: http://blogs.ft.com/maverecon/2008/11/never-mind-…

I would say, though, that they are only used in bankruptcy. So when you talk about moral hazard, you are really talking about people who already face bankruptcy. I think the moral hazard is greatly diminished already as a result. Remember, these are people who have their credit eviscerated for the next seven years. I see this as a quid pro quo: if you are willing to declare bankruptcy, we are willing to allow a third party (a bankruptcy judge) change the loan principle.

The alternative, which I don't see working is to let the bank modify the loan. The problem there is that you DO have moral hazard. The homeowner gets a freebie (except to the degree she owes taxes on the loan forgiveness, which is often the case), while the bank is forced to write down the loan and takes the hit anyway. This is why banks aren't doing loan modifications in greater numbers. Moreover, modifications for some but not for others is another moral hazard favoring home owners with weaker financial profiles. If we do mods, they should be forced o modify EVERY SINGLE LOAN of the same time period to be equitable.

So, I would say the present state of affairs increases moral hazard while cram downs would reduce them. Either way, the government should make any bank recapitalisations dependent on loan modification or cram-downs. That is to say, part of the TARP should be the government guaranteeing to top up a solvent bank's capital base back to where it was before the bank conducted mass cram-downs/modifications. This would incentivize banks to do modifications and cramdowns.

Certainly, that would technically be a bailout. So, you get a new moral hazard. However, there are no really good solutions here. The debt loads are too large for both homeowners and banks.