Should everyone get debt relief?

Paul Krugman in his column this morning argues that debt relief is crucial to economic recovery.  I think he is basically right, but it is not clear to me to whom he would extend debt relief.  If we don't draw any distinctions between those who actively put themselves in trouble and those who are victims of circumstances beyond their control, we will leave the whole concept of the responsibility to repay debt in tatters.  Even if we don't care about the moral implications of this, we should care that if we do blanket discharges of debt, it will be much harder for consumers to obtain debt in the future.

With this is mind, we should probably draw distinctions among different types of borrowers.  Here is a rough ranking of borrowers in some sort of difficulty from most to least culpable for their misfortunes:

(1) Those who committed fraud: for example, those who willfully overstated their income on a loan application.

(2) Speculators who put little or no money down on a house, and then walked the instant house prices fell.

(3) Borrowers who used cash-out refinances or second liens to buy stuff--vacations, televisions, boats, etc.  Michael Lacour-Little estimates that about half of underwater borrowers in Southern California took equity out of their houses.

(4) Borrowers who used cash-out refinances or second liens to pay for education or health care.  Am I drawing a distinction between (3) and (4)? Yes.

(5) Borrowers who had adequate income to repay their purchase money mortgage, did not take money out of their house, lost a job (or took a serious pay cut), and are underwater.

(6) Borrowers who are current on their mortgages and are underwater.  People in buckets (5) and (6) may well be equally responsible; people in (6) may have just gotten a better draw.

As a policy matter, I cannot see providing debt relief to (1)-(3).  While I agree with Krugman that we cannot let worries about moral hazard prevent us from engaging in all debt relief, we cannot just ignore moral hazard altogether.  The tough part, from a policy perspective, is distinguishing between (3) and (4).  I am not sure how we do that, but it is worth thinking about.

As for (5) and (6), at minimum we could allow such borrowers to refinance into today's low interest rates without any fuss: this would both lower payments and the present value of the mortgage, and hence reduce the amount by which people are under water on a mark-to-market basis.

If I had my druthers, people in (5) would be offered a debt equity swap, where the amount owed (the bond) would be reduced, but a large share of any future profit would be shared with the lender.  The Wisconsin Foreclosure and Debt Relief Plan is also worth considering.

Those who were treated fraudulently by lenders (particularly those who had equity stripped via fees) are in another group altogether, and deserve relief.  I am not sure what the correct policy lever is for delivering it.