It looks like Bank of America may have finally begun to realize that reducing principal is the only hope for successfully modifying underwater mortgages. I've written several posts over the past month about the necessity that banks start thinking about using this tactic on their own, if they really hope to modify many mortgages going forward. It can be a smart loss mitigation strategy, even if philosophically repugnant. The government has been pretty reluctant to force banks to do reduce principal, since the associated losses could cause harm to the banking industry. It's interesting to see BOA begin this program without strong coercion.

According to the press release, for the mortgages that qualify, BOA will actually prioritize principal reduction above interest rate reduction. This is a huge shift in modification methodology. Forgiving principal used to be rarely used -- as a last resort. Not all mortgages will qualify. In fact, BOA estimates that only 45,000 mortgages will be eligible for principal reduction under the new program (costing BOA around $3 billion in principal), but the bank is clearly opening the door to this new approach.

This comment by Barbara Desoer, president of Bank of America Home Loans is an important point:

At the same time earned principal forgiveness helps homeowners, it also recognizes and addresses the interests of mortgage investors by ensuring that forgiveness is tied to the homeowner's performance, reducing the probability of a future default under the modified terms, and adjusting the total amount to be forgiven in light of any gains in property values that might occur in an economic recovery.

So what loans qualify for principal reduction? Those that would have qualified for its National Homeownership Retention Program that are at least 60-days delinquent and have current loan-to-value ratios of 120% or higher. Participants must also prove their credit worthiness over time:

- An interest-free forbearance of principal that the homeowner can turn into forgiven principal over five years resulting in a maximum 30 percent decrease in the loan principal balance to as low as 100 percent LTV.
- In each of the first five years, up to 20 percent of the forborne amount will be forgiven annually for borrowers that remain in good standing on their mortgage payments.
- Forgiveness installments for the first three years are set at the 20 percent level.
- In the fourth and fifth years, the amount of forgiveness will be dependent upon the updated value of the property, so that the LTV will not be reduced below 100 percent through principal forgiveness.

This is a pretty sensible approach, because it reinforces the idea that principal reductions will only be provided to borrowers who continue to pay. The plan also protects BOA from losing money over potential appreciation over the next five years. BOA avoids the problem of strategic defaulters as well. Those are homeowners who can afford payments but choose not to because they're unhappy their house is now worth less than their mortgage. BOA intends to make sure borrowers prove they can't afford their original payments prior to modification. All-in-all, it seems like a pretty smart approach.

I have two final observations: First, I'm fascinated to see BOA decide to do this without the federal government demanding it. The bank must have discovered that it's better off with fewer foreclosures, even if that means conceding some principal. Could the rational market actually be working? Second, I wonder if this will prompt other banks to also begin implementing more principal forgiveness. BOA is a hugely significant bank to take this step. Since its acquisition of Countrywide, it has become the biggest mortgage lender around.

Update: I just received an e-mail from Massachusetts Attorney General Martha Coakley's office explaining that this principal reduction program was also part of a settlement with MA that mandated principal reductions. So the program isn't entirely voluntary! More info here.

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