Who Speaks for a CDO ?

It has been asserted that many mortgage servicing contracts are inefficient, because they give the servicer incentives to foreclose even when re-negotiation would be better for the owner of the mortgage. An inefficiency is a profit opportunity. If there are such contracts, then a different contract can generate higher revenue for both the servicer and the final owner.

If this is a problem, then it is especially tricky in the case of mortgages owned by special purpose entities which issued various debt like tranches and an equity tranche (owned by the sponsor). In such cases, for all I know, any renegotiation of the service contract might be forbidden, but I think it is more likely that the sponsor as equity holder could renegotiate the contract with the mortgage servicer. The problem is that, for many CDOs the equity stake is worthless and would remain worthless even if the mortgage servicing contract were improved.

Owners of more senior tranches might benefit from a new contract which is equally valuable to the mortgage servicer, but they don’t control the special purpose entity. The debt like tranches are really more like preferred stock, since failure to make scheduled payments does not constitute default. Owners of those securities can’t ask a bankruptcy court to seize the special purpose entity to protect their interests. So, as things stand, there might be an inefficiency such that no one can profit by eliminating it.

The solution would be for the sponsor to purchase some of the preferred stock like securities, then renegotiate the mortgage servicing contract. Alternatively, an investor could buy the equity tranche (which is worth almost exactly zero) and some of the preferred stock like securities and then renegotiate.

I think there is a possible profit opportunity.

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