Expect to hear the term a lot: principal forgiveness. Forget helping a homeowner by letting him refinance, instead, just forgive some of the loan.

It’s a touchy subject for a lot of reasons. On the one hand, you kinda want to say, “Hey! If someone took out a mortgage he can’t afford, too bad! Why are the financially foolish getting a free gift!”

On the other hand, foreclosures are such a problem — dragging down the economy, stalling the recovery, and so on — that extraordinary measures are called for, even distasteful ones. We need to keep the housing recovery going. (Quoth NY Fed CEO William Dudley: “Households that go through foreclosure need to repair their credit records and to accumulate new down payments. For several years they are no longer available as potential home buyers and this also contributes to softer demand and weaker housing prices.”

On the third hand, economies usually do best when they’re left to work themselves out. It might be best to let the foreclosure mess run its course and deal with the pain if we want a meaningful, long-term recovery.

But on the fourth hand, debt forgiveness is not really that extraordinary: Corporations do it all the time when they seek bankruptcy protection. It’s really the word “forgiveness” that gets teeth grinding. Besides, when the alternative is foreclosure, banks get even less money and people lose their homes — it’s lose-lose.

You’re probably going to be hearing a lot about principal reduction and principal forgiveness. I would urge all of us to keep an open mind about whether it’s good or bad, right or wrong, fair or unfair.

All that said…

Soon to be announced will be the final mortgage settlement (actually, I should probably write that with caps: Mortgage Settlement) between the states attorneys general and lenders who broke various laws while processing foreclosures. Time has an article about it, in which it talks about a $25 billion penalty commitment coming from the banks:

$5 billion in cash payments, mostly to the states, $3 billion in refinancing for underwater mortgages, and $17 billion in principal reduction.

The article goes on:

The bulk of the money—$17 billion—would go to principal reduction for homeowners and a menu of other elements aimed at reducing the impact of the country’s massive housing debt. The $17 billion also is a credit rather than a cash payment by the banks, but it will give some individuals a chance to lower their mortgages.

So that’s one place principal reduction/forgiveness is likely to appear. And there’s more; Federal Reserve Bank of New York President William Dudley called for Fannie and Freddie to also offer principal forgiveness:

I believe we should also develop a program for earned principal reduction for borrowers who are underwater but keep on making their mortgage payments. Such a program would strengthen the incentives for mortgage holders who are underwater to continue to stay current on their loans, and reduce the likely number of defaults and REO sales.

Those two GSEs have (so far) declined the suggestion.

Keep in mind that “forgiveness” wouldn’t be open to anyone who claimed his mortgage is too tough to pay. At the least, the proposals bandied about have said that to be eligible, the homeowner would have to be underwater and — most importantly — current on the loan.