Moral Hazard and the Mortgage Crisis: A good sounding argument that is really dumb

There is a popular notion that we should do nothing to help out underwater mortgage holders.  The theory being that these people knew what they were doing and have to suffer the consequences of their choices.  This moral hazard argument suggests that if we do anything to help out underwater mortgage holders, then people will act badly in the future, thinking that they would just get bailed out too.

Here are some holes in that argument for the current mortgage crisis:
1.  With more foreclosures, there will be a massive decrease in home values, the whole neighborhood will go downhill.  You will have a lot of people moving back in with their parents or moving in with siblings or friends.  You will also have lots of empty homes.  This is bad since you'll be punishing people who did everything right.

2.  No one in their right minds will have a strategic default (meaning purposeful default).  After a default, a person is shut out of the credit market (no credit cards, no car loans, no mortgages) for 10 years.  After 10 years, they'll be high risk and have to pay far higher interest rates.  Can you imagine how crappy that would be?

3.  With little hope of keeping their homes, homeowners will not take care of repairs nor keep the home in good condition.  Banks know this and they know that they want to keep people in their homes.  The only people who don't give a crap are Mitt Romney, Rick Santelli (the Chicago Merchantile Exchange guy on CNBC), and self-interested speculators (me?).

Only one solution works effectively: principal reduction.  When the farm states were having their own mortgage crisis in the late 1990s, the banks reduced principal on the farmers' mortgages and a greater crisis was averted.  This idea is highly unpopular with powerful, financial interests because it reduces the potential money that they will be paid back.  However, principal reduction increases the chances that the homeowner would be able to afford the mortgage.

Banks should view the current crisis as viewing underwater mortgages as companies in distress.  In these situations, companies and banks would negotiate terms to best increase the odds of the company surviving and paying, at least a portion, of the loans owed.