I hate to take issue with someone making an argument that I essentially agree with, but Joe Nocera’s case for principal reduction does have a major flaw. The gist of Nocera’s argument is that people are losing their homes and that because of tighter lending standards, new buyers will not be able to replace them. He argues that this will lead to massive oversupply and therefore further downward pressure on prices.

Okay, boys and girls, you have 3 minutes to figure out what’s wrong with this picture.

Time up? Okay, can you say “rent?” You see, if it really proves to be the case that we get the promised glut of ownership units then something magical happens to them. They become rental units. In the story described here we should see rents rising sharply relative to sales price since so many more families are now restricted to the rental market.

And, if rents are rising and people can’t sell their homes, then they rent them out: horrible problem solved. (Those who think this doesn’t happen should look at the data. Almost one third of rental units are already single family homes.)

So banks should be persuaded and pressured to do principal reductions. They should also be persuaded and pressured to allow people to stay in their homes as renters following foreclosures. Nocera is right on the policy, but he’s stretching a bit in making the argument.