There has been a big push to address the current mortgage crisis via mortgage modifications, notably by Sheila Bair of the FDIC. For most borrowers, modding down loan principals to house values generally just recognizes reality; most borrowers either can't or won't pay far more than the value of their house to live in it. However, a lot of mods just reduce interest rates - here's a particularly spectacular million-dollar 1% balloon loan from WAMU. Not only do these mods not acknowledge reality, they are adding to the toxic debt problem.
A big part of toxic debt, and arguable the worst for the financial system, is debt which cannot be accurately valued by any method. This can arise from exceedingly complicated derivatives, but a relatively new problem arises from our being in uncharted economic waters. Predicting the value of a long-term security requires projecting the future, which in turn must be done with models from the past. However when you're in a strange and unprecedented situation, old models aren't going to be accurate. This means long-term securities become un-valuable - nobody can figure out what they're worth. Since market mechanisms are just an opinion-averaging system, market prices are as arbitrary and meaningless as the unfounded opinions they're based on.
When you have this "mystery meat" toxic debt, it becomes impossible to fix companies reliant on it, even with unlimited resources. There's no way to know how much to allocate to cover losses. Too little means the company is still bad. Too much is an unfair windfall. And almost any amount could be either - there's no way to know, except to wait and find out.
This WAMU balloon loan is exhibit A for a "mystery meat" toxic debt. What will currently overpriced houses be worth in 5 years? We have no idea, basically. How much of the underwater amount will the borrower be able to cover? We have no idea. How possible will it be to get a rollover loan in 5 years? We have no idea. So, what had been a relatively easy-to-value foreclosure has become a million-dollar slug of toxic mystery meat which has to molder on the plate for years until it can be resolved.
Instead of the garbage getting taken out, it's been added to the food. We are worse off than before. I'm all for constructive loan modifications, but these kinds of mods have to stop.