Bank of America to Eat Part of Home Loans

(Bank of America loan modification details added to this update.)

CHARLOTTE, N.C. ( TheStreet) -- Bank of America ( BAC) is taking a dramatic step toward righting its most troubled mortgages, with plans to forgive up to 30% of loan principal in some cases.

Bank of America, the country's biggest home lender, announced a plan on Wednesday to begin examining principal forgiveness ahead of rate reduction when modifying its "most severely underwater" loans. Subprime, pay-option and prime two-year hybrid mortgages will be eligible for its newly formulated program if they are at least 60 days delinquent.

The move is likely to lead to writedowns but also help the most struggling homeowners who don't qualify for help through a federal workout plan. Bank of America's plan will target borrowers who owe more than 120% of what their homes are worth, and offer interest-free forgiveness on loan payments, as long as they stay current. It expects to implement the plan in May and extend its overall workout program for six additional months, through Dec. 31, 2012.
Foreclosure

The plan is targeting the ever-growing pool of "negative amortization" borrowers, which has grown as home values have continued to decline. This pool of borrowers is one of the most troubled, because they have lost all equity in the asset and have little incentive to pay. Some have stayed in homes without making mortgage payments for months until foreclosure proceedings get under way, and only leave once evicted. As they pocket and save monthly mortgage payments until evicted, it's a lose-lose situation for both bank and borrower.

Barbara Desoer, president of Bank of America Home Loans, pointed out that the plan will also lessen the amount of principal forgiveness if property values rise, and reduces the probability of future default by making monthly payments more reasonable.

"At the same time earned principal forgiveness helps homeowners, it also recognizes and addresses the interests of mortgage investors," she said in a statement.

Bank of America's strategy is important, because as the largest mortgage servicer in the country, it can set standards for the rest of the industry. It also represents a shift in the industry's thought process from battling loan losses and attempting to push out troubled borrowers, to implementing programs that may stabilize the shaky housing market. Consumer groups and some academics have criticized the Obama administration's Home Affordable Modification Program as ineffective for more than a year , and advocated principal-forgiveness as a better alternative.

Bank of America had been criticized for lackluster HAMP, relative to other big lenders like JPMorgan Chase ( JPM) and Citigroup ( C). However, Bank of America has turned up the dial in recent months, moving many more trial modifications into permanent ones. Many of its problem loans came through the Countrywide acquisition, but problems have bled through even to once-prime real estate in its legacy division as the housing crisis has escalated.

It's unclear how much Bank of America has in exposure to negative amortization loans, or what the impact of this program will be for investors over the short term. Its purchase-impaired portfolio related to Countrywide stood at $33.7 billion. It had $242.1 billion in overall residential mortgage exposure, of which 8% was 30 days or more past due. Nonperforming assets accounted for $17.7 billion.

Bank of America isn't the only major lender to publicize unorthodox strategies to keep borrowers current. Wells Fargo ( WFC) has been a leader in this sense, offering the most troubled homeowners from its Wachovia acquisition a seemingly generous incentive. Borrowers in this "Pick-A-Pay" portfolio -- who were once able to choose their own monthly payments, even if it fell below interest level -- can now pay interest-only over the next six-to-10 years.

At most of the major banks, problem loans have continued to rise, but the rise has leveled out a bit, indicating that they may be near the end of the loan-loss cycle. Getting ahead of the next problems, as Bank of America and Wells Fargo appear to be doing, may be the quickest way to move forward from the housing crisis.

-- Written by Lauren Tara LaCapra in New York