More than 200,000 financially strapped households will have a chance to sharply reduce their mortgage balances under a side deal negotiated by Bank of America Corp. that could allow the bank to avoid as much as $850 million in penalties.

Under the arrangement, part of the recent $25 billion settlement of alleged foreclosure abuses between government officials and five large lenders, Bank of America will make deeper and broader cuts in balances than other banks.

The plan will offer qualifying borrowers a chance to cut their mortgage balances to their home's current market value. Other banks are required under the national settlement to cut principal to no more than 120% of the home's value.

Borrowers who qualify are expected to receive principal reductions averaging more than $100,000, a Bank of America spokesman said. The pact's total value will depend on how many borrowers take up the offer.

The agreement is the latest twist in the government's long-running effort to break a logjam in the housing market, by pushing lenders to cut loan balances to make it easier for borrowers to stay in their homes.

The move is likely to generate criticism from investors who own securities backed by mortgages that could be affected by the settlement.

Although many investors support principal reductions when their benefits outweigh the cost of foreclosure, many worry that some of the principal reductions triggered by the settlement will reduce returns on the securities.

Some fund managers also feel that it is unfair for banks, which serviced mortgages on behalf of investors, to use those same loans to meet their obligations under the settlement.

"The fact that a servicer has done a poor job has already impacted borrowers and our investors," said BlackRock Managing Director Randy Robertson, who declined to speak specifically about the Bank of America agreement. "To ask investors to pay for banks' fines in any form seems inappropriate and incorrect--we have very serious issues with that."

Bank of America is responsible for the largest chunk of the $25 billion settlement. The company is on the hook for $3.24 billion in cash payments to federal and state governments, along with $8.58 billion of principal write-downs, refinancings and other assistance.

The side deal is unique to Bank of America and was the product of negotiations covering both mortgage originations and servicing, according to a senior Obama administration official.

The expanded program could allow Bank of America to avoid paying $350 million in cash penalties tied to the foreclosure settlement and half of a separate $1 billion penalty related to a settlement of false claims filed on loans backed by the Federal Housing Administration, if the bank meets certain targets. Many of the write-downs will be made on loans originated by Countrywide Financial Corp., which Bank of America acquired in 2008, and then packaged into securities.

The Obama administration official said that principal reductions will be done only when there is a benefit to investors, meaning that the cost of the principal reduction will be less over time than taking the loan through foreclosure, and the principal reduction is done in accordance with investor contracts. "The misunderstanding somehow that the investors will be paying the banks' share is just false," Secretary of Housing and Urban Development Shaun Donovan said when the deal was announced last month.

Details related to the settlement are likely to emerge in the next few days when the final agreement is filed in court. The settlement with Bank of America and four other of the nation's largest banks--Ally Financial Inc., Citigroup Inc. (C), J.P. Morgan Chase & Co. (JPM) and Wells Fargo & Co. (WFC)--resolves state and federal investigations related to questionable foreclosure practices.

Under the broader settlement, banks must provide at least $10 billion in principal reductions. They receive full credit for reductions on loans they own, and 45% credit on loans owned by investors.

Under its deal, Bank of America must continue to offer principal reductions to all eligible borrowers even after it meets its formal obligations under the settlement, the Obama administration official said. Government officials hope that the broader settlement will pave the way for more widespread principal reductions. Mortgage-bond contracts sometimes allow for principal reduction when it is found to have a positive economic value for investors.

It isn't clear the extent to which other banks will write down balances on investor-owned loans as part of the settlement. Ally Financial "will be pursuing opportunities on our owned portfolio at this point," a company spokeswoman said.

Other banks said they are likely to reduce principal on some investor loans. Wells Fargo "will continue our practice of modifying loans in private-label securities and for those that allow it we will continue our practice of principal reduction," a company spokeswoman said.

A Citigroup spokesman, while declining to comment on the settlement, said that the bank has been doing principal reductions on investor loans when it is "in the best interests of our investors and allowable under servicing agreements.... We will continue to do so going forward."

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