NEW YORK (CNNMoney.com) -- Bank of America announced Wednesday that it will first look at reducing the loan balances of certain distressed homeowners with subprime or adjustable rate mortgages to make their payments more affordable.
The move makes Bank of America (BAC, Fortune 500) one of the first major loan servicers to systematically incorporate the controversial loan modification technique into its home retention program. Financial institutions, as well as the Obama administration, have come under increasing pressure in recent months to add principal reduction to their foreclosure prevention efforts.
Housing experts argue that borrowers are more likely to walk away if their mortgages are underwater, meaning they owe more than the home is worth. Nearly 25% of borrowers are underwater, according to First American CoreLogic.
Bank of America is launching the program to entice more borrowers to participate in its foreclosure prevention efforts and to reduce the chance of redefault, said Barbara Desoer, president of Bank of America Home Loans.
When modifying mortgages, Bank of America will initially consider reducing the balances of borrowers with qualifying subprime, Pay-Option ARMs and prime 2-year hybrid ARM loans to bring down the monthly payments to 31% of pre-tax income. Currently, banks first look to reduce interest rates or lengthen the term.
Homeowners who are at least 60 days late and whose mortgages total more than 120% of their home's value can have their balances reduced over five years by a maximum of 30%. Borrowers must also meet the criteria for the president's loan modification program.
"Bank of America has found that many homeowners who owe considerably more on their mortgages than their homes are worth are reluctant to accept a solution that addresses only the amount of the payment without an accompanying reduction in the balance due on the loan," said Desoer.
Borrowers also must qualify for the servicer's National Homeownership Retention Program to be considered. The initiative was developed as part of Bank of America's 2008 settlement with state attorneys general to assist Countrywide Financial Corp. borrowers with subprime and Pay-Option ARMs.
The settlement called for Bank of America, which acquired Countrywide in July 2008, to modify troubled mortgages with up to $8.4 billion in interest rate and principal reductions for nearly 400,000 Countrywide customers.
The bank expects that 45,000 borrowers will qualify to have their loan balances reduced by a total of $3 billion under the program announced Wednesday. It is set to begin in May.
Pay-Option ARMs allow borrowers to make tiny monthly payments, but the unpaid interest is tacked onto the mortgage balance, a practice called negative amortization. Two-year hybrid ARMs have a fixed interest rate for the first two years, but adjust after that.
Under the "earned principal forgiveness program," borrowers will receive an interest-free forbearance of principal that can be turned into forgiveness if the homeowner makes timely payments over five years.
The ultimate amount forgiven depends on an updated appraisal of the property. Bank of America will not reduce balances below 100% of the home's value.
These conditions will also make the program more attractive to investors because it should reduce the probability of redefault and adjust the amount forgiven if home values rise, Desoer said.
The servicer is also making changes to its National Home Retention Program. It will reduce the negative amortization on Pay-Option ARMs through principal forgiveness and will convert the loans to ones that don't build up the balance.
It will also expand the program to cover Countrywide loans originated on or before Jan. 1, 2009, and will extend the program by six months to the end of 2012.
Many housing experts, lawmakers and even some mortgage investors have been pushing servicers to reduce loan principal. But Treasury officials and bank executives have said they are concerned about the "moral hazard" of helping those who don't truly deserve or need it.
Still, experts say that principal reduction is a must, especially in areas hit hard by falling home values.
"Principal reduction is an important tool in making loans sustainable for many borrowers," said John Taylor, head of the National Community Reinvestment Coalition, who praised BofA's effort. "The rest of the industry should follow suit. And federal policy should reflect the growing consensus that principal reductions are required to stem the foreclosure crisis..."
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