The underlying issue for both the high foreclosures and big bank failures we’ve observed is that house prices are falling. When the price of any asset (such as housing) falls, losses are incurred.
Equity holders suffer the first losses. In the case of housing, the equity holders are the homeowners. If the losses are large enough to wipe out the equity, the ownership of the asset is transferred from the debt holder to the equity holder. (In the case of housing, this is foreclosure). Debt holders then absorb any other losses. With housing, the holders of the debt are the institutions or people that own the mortgage notes.
The price of housing has fallen rapidly enough that many homeowners had their equity wiped out -- leading to high rates of foreclosure. The losses were steep enough that in many cases the debt holders have also taken losses, which led to the high rate of failure of mortgage holders (such as Lehman Brothers, etc.).
The point of all this is to say that someone needs to take losses because of falling house prices. A “foreclosure moratorium” or widespread “mortgage modification” would reduce the losses suffered by homeowners (equity holders) and increase the losses suffered by mortgage holders (banks and financial institutions). Thus, a moratorium does not correct the fundamental problem, the decline in house prices. It just shifts losses around.
A policymaker might say, “Let’s just let those ‘greedy’ banks and financial institutions absorb the losses.” There are two problems with this. First, our banking system appears quite fragile right now. Many economists are worried about a deep recession because lending institutions, i.e. banks, are not lending very much right now because of the losses they have already absorbed. Any future losses absorbed by banks might make them even more hesitant to lend. Second, because of FDIC insurance, the government is effectively a large debtholder in many financial institutions. Thus, any moratorium on foreclosures or widespread forced mortgage modifications would effectively shift losses from many households engaged in somewhat speculative behavior (i.e. zero-down mortgages) to mostly responsible taxpayers (i.e. those households that chose not to refinance their housing with zero-down).
Personally, I think a brief foreclosure moratorium is worth considering as a method for developing an orderly process for dealing with the large number of defaulted mortgages. We just don't have the servicing infrastructure to deal with them all right now.