This latest “sudden debt” post pointed my attention to what actually happened yesterday. When Bernanke suggested that lenders are better off to write down part of the principal it’s not just another another call for mortgage reworking. It’s a paradigm shift.

During the normal times the bankers have no intention to facilitate the debt burden for any borrower because any preemptive help creates moral hazard and make other borrowers to misbehave. Bankruptcy proceedings are a good way to keep peers on leash.

But now is not the normal times. We are in Kondratieff Winter and the orthodox wave theory says that the Winter is a time of massive deleveraging, i.e. the outstanding debt must decline sharply. All asset prices are bound to fall and all Ponzi units are bound to fail. Read more about Ponzi units here.

The whole idea that preemptive write-down of principal could be more financially sound than sticking to the contract means that Bernanke is recognizing the fact that once you apply some simple quantitative financial conditions filter the Ponzi units will outnumber non-Ponzi units within the filtered set. That means that by reducing the principal for the whole working set you are mostly helping the Ponzi units rather then have a moral hazard of helping non-Ponzi units. And reducing the principal is the most sound way to deal with Ponzi unit. If we were not in Kodratieff Winter one would expect the collateral to start rising again, but Bernanke just demonstrated that he has no illusions.
In simple example, it’s obvious that writing off 5% of the mortgage balance is much better then losing 50% of the loan in foreclosure. Any temporary measure, like freezing the rate is not working, because the borrower with negative equity is not motivated even by reduced rates, but he is motivated if his equity is made positive.

This approach is universal and now Bernanke is trying to gently point the banking community in the right way before it’s too late. Now it’s just a mortgage market, but then it will be municipal, corporate and commercial real estate markets, all marching into massive defaults. I expect massive writedowns of principal as a suggested mutually-beneficial way to end the Winter and move into Spring. Should take time though