Eminently sensible?

New Yorker:  Letter From California - Home Economics
 Mortgage Resolution partners has an idea for solving the foreclosure crisis - localities should condemn underwater properties (properties whose market value is below the principle of the mortgage on the property) and then reissue the mortgages at a lower principle value.  Their argument goes something like this:

A homeowner gets a USD 300,000 mortgage to finance a home purchase.  After he buys the house the value of the home falls to USD 200,000.  Who is now at risk?  Answer - whoever is the current holder of the mortgage.  Should the homeowner continue to pay the mortgage then eventually the mortgage holder will get paid back.  However should the homeowner default and be foreclosed upon then the mortgage holder will take possession of an asset only worth USD 200,000 and will hence realize a USD 100,000 loss - at least.  The process of foreclosing and reselling incurs some cost as well so the loss to the mortgage holder is greater than USD 100,000.

From the above argument it is easy to see that if a property goes underwater then it is in the mortgage holders interest to keep the homeowner in the house and paying the mortgage.  In fact faced with an imminent default by the homeowner it should be in the mortgage holders interest to reduce the principle value of the loan down to the market value of the home rather than foreclose and realize the same loss plus some additional charges.  Some banks have in fact been reducing principle values (see here) but there are three outstanding problems:

1. The bargaining problem.  If a homeowner know that a mortgage holder will reduce the principle value of his loan if the homeowner is about to default then it is in the homeowners interest to threaten to default.  How does the mortgage holder distinguish between a homeowner who really is about to default and one who would continue paying the existing mortgage?
2. Many mortgages (especially recent troubled vintages) are not currently held by a single party but were sold off to SPVs who sliced and diced the cash flows into RMBS and sold the resulting securities off to many investors.  Modifying these mortgages prior to an actual default may be very difficult.
3. If a mortgage issuer reduces the principle then he must realize the loss from an accounting standpoint.  If the homeowner defaults and the mortgage issuer sells off the property at market value below principle value then the mortgage issuer must realize the loss from an accounting standpoint.  However if the mortgage issuer can keep the homeowner paying the original mortgage then he does not need to realize any loss - at least not yet.  This clearly produces a bad incentive to push the problem off into the future.

Mortgage Resolution Partners plan goes like this.  The locality would use its power of eminent domain to seize the mortgage.  They would pay the current mortgage holder ( SPV / bondholder / ) 80% of the current market value of the property (which would be USD 160,000 in the above example).  The locality would then arrange for a new mortgage with principle value equal to 95% of the current market value of the property (which would be USD 190,000 in the above example).  The 15% difference between the value of the new mortgage and what was paid to the former mortgage holders would be divided between the locality, the issuers of the new mortgage, closing costs for the new mortgage, and USD 4,500 for MRP.  Mortgage holders hate this plan for two reasons

1. The bargaining problem again.  Why reduce the mortgage for a homeowner who would have paid the full principle value off anyways.  The homeowner purchased an asset that declined in value and now the mortgage holder is being penalized for it.
2. The mortgage holder only receives 80% of the current market value of the property.  MRP argues that 80% is where Fannie and Freddy have marked their own portfolio.  The mortgage issuers argue that MRP and the localities are just stealing 20% of the principle value for themselves.
3. The mortgage issuers are forced to realize the loss today.  They don't come right out and say this but it is obviously a disincentive.