An unintended consequence of the TARP-and-switch

The fact that there are many bondholders with interests in a securitized loan is not necessarily what stands in the way of modifying that loan. The documents creating the securitization trust that holds the actual mortgage will usually delegate authority over modifications to a "special servicer" (at least that was the case in the securitized commercial real estate loans I've dealt with). But even if you can figure out who the "special servicer" is, there are more stumbling blocks: Under the tax regulations that govern REMICs (the tax classification that applies to most securitization trusts), loan modifications are generally prohibited unless the loan is actually in default or default is "reasonably foreseeable". And the special servicer entity is often owned by the same folks who own the riskiest tranches of the bonds issued, on the theory that they would have the most interest in watching over the status of the loans. But since those riskiest tranches are now worthless, the special servicer may not be very motivated to pay attention to loan modification requests. Or the special servicer may be a subsidiary of Lehman Brothers or some other defunct or crippled Wall Street house whose operations are now in total chaos at best.

My half-informed understanding of the history of debt securitization and REMICs is that they arose in response to the mid-80's savings and loan and bank problems. The regulated lenders were having trouble meeting regulatory capital requirements. Wall Street got creative and, by bundling loans, slicing them into tranches and convincing the rating agencies to assign AAA ratings to the best tranches, was able to buy pools of loans from the banks and sell them back some AAA bonds that helped the banks meet regulatory capital requirements. Presto! – Your risky real estate loans have now been replaced by low-risk bonds, carved out of pools of the same loans. The tax law was amended to create the REMIC entity that could hold a pool of loans without paying corporate income tax. To keep REMICs from acting like banks, the tax law includes severe restrictions on their ability to modify loans. So we got a shadow banking system that, in addition to giving us indecipherable securitization structures, is prohibited by tax regulations from pro-actively modifying loans before they become distressed.

The law of unintended consequences was enforced with a vengeance on the creation of the debt securitization industry. It will be fun to see what new unintended consequences will come out of the measures now being taken to rescue us from the collapse of that industry.

"The solution, free-marketeers will be glad to know, isn't less ownership but better ways to aggregate it. Consider the patent pool created in 1917 that let airplanemakers swap technology and share profits without threat of litigation. For property use, Heller imagines something like a co-op board for landowners. Suddenly, there's someone in charge to talk to--and maybe that airport gets its runway."

I think that you're right here, but not about these bundled mortgages. The problem is that the servicers have no incentive to do this, and the holders are betting on a government subsidy as of right now. They have learned from TARP. But then, I find that many people who appear perplexed by the complexity are quite aware about they're doing.