Will big banks and servicers try to make good on their foreclosure processing transgressions by providing more aggressive mortgage modifications to struggling borrowers? That appeared to be an underlying theme of a draft settlement that state attorneys general offered last month. It sought to coerce banks into embracing mortgage principal reductions, which up to now have been rarely utilized by banks when modifying mortgages. A report today indicates that banks consider principal reductions off the table, however. This isn't very surprising.

David McLaughlin at Bloomberg provides an update on the settlement talks today. He says that many details have been ironed out, but there are a few sticking points. Here's a big one:

An accord remains out of reach because states want principal reductions for borrowers, which is more than banks agreed to in deals reached with U.S. regulators last week, said Allison Schoenthal, a lawyer at Hogan Lovells in New York.

"Principal reductions I don't think are going to be agreed to by banks, and I don't think the banks see a need for a penalty when, in their view, they haven't done anything wrong," said Schoenthal, who represents lenders and servicers and isn't involved in the talks.

Haven't done anything wrong? If the banks really are squeaky clean here, then they might be better off taking the case to court. Their legal fees could dwarf losses they incur due to a settlement that involves big cash damages or principal reductions. But perhaps they worry the cost of a messy legal battle would instead surpass the cost of a settlement.

As the Bloomberg article indicates, federal regulators agreed to a deal with the big banks and servicers last week. The enforcement action amounted to little more than a gentle scolding and a license to take even longer delaying foreclosures from hitting the market. The deal provides banks with a more solid footing when arguing that they should not face any monetary consequences.

It's hard to imagine that banks would not face any loss-inducing consequence, however. The state attorneys general appear angrier about the situation than federal regulators. So we could see some monetary damages result. But banks would almost certainly prefer a modest, one-time lump sum penalty to finally embracing principal reductions, which is likely why the settlement talks are stalling.

Banks have been strongly opposed to principal reductions for years, because they worry about the slippery slope that could result when the modification strategy is used. Once they start cutting the mortgage balance of some underwater homeowners, everyone will want their fair share. Strategic defaults could skyrocket, as other underwater homeowners seek relief -- even those that can easily afford to pay their now overpriced mortgage. That would further push down home prices and cause even bigger losses for the banks. If banks have to sustain losses of even a fraction of growing $751 billion of underwater mortgage balances, the industry could be devastated.

So if banks have to pay anything, they would likely prefer a lump some to principal reductions. At least with a lump sum the pain will be akin to pulling off a Band-Aid. The loss may hurt, but the pain will be limited and certain. Principal reductions would open banks up to large losses that would be difficult to estimate.

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