For more than a year, the mortgage industry has resisted calls to reduce principal for troubled homeowners en masse. Bank of America Corp.'s agreement to do so for 45,000 borrowers shows that in certain cases, there is now little left to lose, and perhaps something to gain, from such actions.
On Wednesday the company said it would offer "conditional" principal reductions to this group of underwater borrowers, all of whom had taken out loans from Countrywide Financial Corp., which B of A acquired in 2008. B of A said it would forgive up to 30% of the principal for these people as long as they continue paying their mortgages for five years.
To qualify, a loan's balance must be at least 120% larger than the current value of the home. All the loans involved are either option adjustable-rate mortgages or hybrid ARMs, two products that were popular during the housing boom.
While the modifications are part of a settlement with the Massachusetts Attorney General's Office, which had accused Countrywide of predatory lending, they don't exactly constitute a pound of flesh from B of A.
"B of A has already taken significant marks to these loans," said Jefferson Harralson, a managing director at KBW Inc.'s Keefe, Bruyette & Woods Inc.
He noted that early last year B of A charged off $17 billion of a portfolio of option ARMs that Countrywide had originated, which had an unpaid principal balance of $22 billion.
"Because these loans are so far underwater and have been charged off, it's a good deal for both the bank and the borrower," Harralson said.
Jack Shackett, B of A's head of credit-loss prevention, said as much.
"There is significant upside for us in this process," he told reporters on a conference call Wednesday.
Barbara Desoer, the president of Bank of America's home loans unit, said on the call that by reducing principal B of A hoped to "increase the acceptance of modification offers and the sustainability of those loans."
She said the company had tested the strategy with a smaller group of underwater borrowers who were 60 days or more past due. B of A offered to reduce principal by 25%, and thereby cut loan-to-value ratios to 110%, for this test group. Thirty percent of the group responded, Desoer said.
That is a strong response rate these days; some servicers have said they are happy when 8% of the delinquent borrowers they contact respond.
Most observers said other servicers may well replicate B of A's targeted approach to principal reductions, though they disagreed on how soon and how often that would happen.
"This could be a game-changer," said Steve Horne, the president of Wingspan Portfolio Advisors, a specialty servicer in Carrollton, Texas. "There has been a lot of resistance to meaningful principal reductions on a large scale, and this may herald the advent of that strategy."
The change may occur as more mortgage executives conclude that the housing market is going to enter a "double-dip recession," Horne said, and principal forgiveness has proven to be one of the few successful strategies to keep defaulted borrowers paying their mortgage.
William Longbrake, an executive in residence at the University of Maryland's Robert H. Smith School of Business and a former vice chairman of Washington Mutual Inc., said whether other servicers adopt a similar strategy is unknown because B of A's plan is limited to certain loan types.
"Pay-option ARMs are very ugly so those are where principal reduction does make sense," he said.
Whether other banks agree to cut principal largely depends on whether they have already taken such chargeoffs, Longbrake said.
"Most of the banks that have portfolio loans where they haven't marked them to market have been tremendously resistant because of the hit on accounting," he said.
Greg Hebner, the president of MOS Group Inc., an Irvine, Calif., company that contacts troubled borrowers on behalf of lenders and servicers, said B of A was setting a precedent by adopting different practices for different borrowers, which could backfire.
"You're starting to raise serious issues of unequal treatment and potentially creating an extremely perverse incentive," Hebner said. "If I'm a subprime borrower who is 60 days delinquent, I can get a principal reduction, but those who received a fixed-rate loan cannot."
Harralson at KBW said B of A's requirement that the borrower continue paying for five years to get the upside principal reduction was a "long trade for the borrower."
"With a loan so far underwater, it makes sense to trade 4% of the principal in a year for the borrower to stay in the home," he said. "This type of idea will most likely be employed by other banks that did aggressive lending."
The B of A agreement applies only to loans that are eligible for the Treasury Department's Home Affordable Modification Program. All the loans are either held in B of A's portfolio or serviced by B of A for investors who have delegated it the authority to modify loans. Loans held by Fannie Mae and Freddie Mac are not included, nor are borrowers with second liens.
"These solutions are tailored to a very narrow set of customers," B of A's Shackett said. "The whole purpose of the program is to get more customers to return our calls, accept our offers and make their payments."
The agreement came just as a government watchdog report derided the year-old Hamp as poorly designed.
In a report released Wednesday, Neil Barofsky, the special inspector for the Troubled Asset Relief Program, criticized Hamp for, among other things, failing to require servicers to address negative equity.
"In light of the amount of negative equity in the mortgages under trial modifications" under Hamp, "resulting redefaults, including strategic defaults, may be a factor as borrowers decide that it makes more economic sense for them to walk away from their mortgages, and rent at a lower cost, rather than continue to make payments that may never result in them obtaining equity in their home," Barofsky wrote.
Under Hamp, the Treasury focuses on reducing the monthly payments to 31% of the borrower's income.
All the 170,207 permanent modifications completed under the program as of the end of February included an interest rate reduction, and 40.8% included a term extension.
Only 27.8% included principal forbearance.