loss must be ormally recognized in a manner that bearssome intelligible relation to home
loss. Moreover, ormuch underwater mortgage debt, write-downs raise value—abenet borne out by the requency with which portolio loanholders write down debt (Olick 2012; Goodman et al. 2012;Ritholtz
2012; Goodman 2012).Write-downs are not easily carried out in all cases, however.Much depends on whether the targeted loans are held in bank portolios or by private-label securitization trusts. In the port-olio case, write-downs occur at signicant and still growingrates (Goodman et al. 2012; Goodman 2012; Streiteld 2011).Bank ocers know that underwater loans oreclose at highrates, with the result that expected values all needlessly shorto ace values; hence, they nd it nancially rational to writedown these loans. In so doing, they benet not only them-selves, but also their debtors and the communities in whichthey reside. In this case, the interests o all parties converge.Securitized mortgage loans, however, pose a problem.While it would be no less rational or benecial to write theseloans down, certain structural eatures o the loans—eaturesthat now act as market ailures—prevent the rational thingrom being done. Te upshot is deadweight loss—loss whoserecoupment and equitable distribution is one object o theplan sketched below.
Structural Impediments to Write-Downs
What are these structural impediments? A host o classiccollective action problems, reinorced by dysunctionalcontract provisions, stand in the way o the optimal solution(Hockett 2012a, 2012b; Shiller 2012). For one thing, there isa last-mover advantage where write-downs are concerned,owing to the benets (positive externalities) that accrue tothe creditors on later loans when principal is reduced onearlier loans. Tis problem aficts portolio loans too, o course, and probably thereore keeps modication rates lowerthan optimal even among banks. But in the case o privately securitized loans, it is reinorced by additional challenges.Most decisive among the additional challenges is that somany o the pooling and servicing agreements governing theprivate securitization o loans—agreements draed during thebubble years when ew oresaw a marketwide housing price bust,and many rushed either to push or to purchase an innovativeproduct—require supermajority voting among mortgage-backedsecurities (MBS) holders beore loans can be modied or soldout o trusts. And these bondholders, geographically dispersedand unknown to one another, cannot collectively bargain withborrowers or buyers on workouts or prices.Moreover, the agreements governing the loans preventtrustees and loan servicers, who are duty-bound to act onbehal o the bondholders and thus could in theory addresstheir collective action problems, rom modiying or sellingo loans in the requisite numbers (Hockett 2012a, 2012b).
Finally, the agreements typically stipulate compensationarrangements that make it more protable or servicers tooversee lengthy oreclosure proceedings than to seek modica-tion.
In sum, then, these contracts now virtually ensure thatmortgage loans will deault, harming all interested parties.Additional complications arise rom the act that many underwater homes are subject to second liens that secure homeequity lines o credit or closed-end second mortgages. Firstlienholders benet little rom loan modications unless secondlienholders modiy too; hence, they are rationally reluctant tomodiy on their own. But second lienholders eel less pressureto modiy because borrowers, strapped by post-bust liquidity needs or which home equity lines constitute precious sourceso credit, are apt to make payments on them rst—a reversalo the legal order o creditor priorities (Goodman 2012).
Inaddition, the second lienholders quite oen are banks—thesame banks that service the rst-lien-secured loans. Tatposes a conict o interest where rsts preer that secondsmodiy too in order to optimize the benets that modica-tion brings to rsts, urther obstructing agreement amongborrowers and creditors.Other constraints—including inapplicable bankruptcy laws and Internal Revenue Code and rust Indenture Actuncertainties—impede the kind o collective action that wouldbenet both debtors and creditors (Hockett 2012a, 2012b). Butthe oregoing discussion suces to indicate how ormidablethe obstacles to principal write-downs can be, particularly orloans held in private-label securitization trusts.
Bypassing the Impediments through Collective Agency
Solving a collective action problem requires a collective agent.O course, that is what PLS trustees and servicers in theory are.But as we have seen, these agents are oen hand-tied or con-icted. Who, then, will act or the creditors and, in so doing,or homeowners and spillover victims o local oreclosure andthe continuing weakness in the U.S. mortgage market?As it happens, governments are also collective agents. Tey are likewise the sole entities authorized to sidestep the contractrigidities o the pooling and servicing agreements that stand inthe way o broad write-downs or PLS loans. But
govern-ment should take up this mantle—ederal, state, or local?
In some cases, or example, pooling and servicing agreements allow no morethan 5
percent o the loans in the pool to be modied. Tis
percentage, whichshows how little the marketwide crash was expected, has long since beenreached in the case o most loan pools.
Lee, Mayer, and racy (2012) oer a contrary view, nding that by the time aborrower goes delinquent on the rst lien, there is little credit available on thehome equity line.