The basic problem with valuing underwater loans is that borrowers are heterogeneous. Some borrowers are going to walk away from their mortgages; from the standpoint of financial institutions, it would be better to simply write down their mortgage balance, swap the value of the debt above the mortgage balance for equity, and avoid foreclosure.
But other borrowers insist on paying their mortgages, no matter what. These mortgages continue to be worth something like their par value. Financial institutions do not want to modify their loans. But if those who pay their mortgages know that those who don’t will get a modification, they will change their behavior.
So the optimal program (from the lender’s perspective) would be one that identifies those who wouldn’t repay, and then grant those people a secret modification. I can’t figure out how to either (1) how to do the identification or (2) write to contract binding the borrower to secrecy.
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