The Wall Street Journal reported this morning that Bank of American (BOA) has struck a side deal with the government that would cut penalties assessed against it in return for making deeper cuts to the mortgages of distressed borrowers.

The recent $25 billion dollar settlement between BOA and four other major lenders and the U.S. Justice Department, federal regulators, and 49 of the states' attorneys general would have obligated BOA to pay as much as $850 million in penalties and to cut the outstanding balance of principal for some borrowers to a maximum of 120 percent loan-to-value.  Under the new agreement BOA would cut the outstanding balance down to the market value of the collateral property and is expected to reduce the average mortgage by about $100,000.  A BOA spokesman said the final value of the agreement will depend on how many borrowers take up the offer.

On February 9 BOA explained to its investors that its obligations under the multi-bank settlement would total $11.8 billion and include the following:

• Approximately $7.6 billion in borrower assistance, including targeted principal reduction.
• Approximately $1.0 billion in refinancing assistance to customers in the participating states.
• Approximately $2.25 billion in direct payments to state and federal governments and in borrower restitution, of which $1.9 billion would be an upfront cash payment and the remaining $350 million, would be paid only if Bank of America failed to meet certain principal reduction thresholds over a three-year period.
• Up to $1.0 billion in payments to settle FHA claims, of which $500 million would be an upfront cash payment, and the remaining $500 million would be paid only if Bank of America fails to meet certain principal forgiveness levels over a three-year period.

The new agreement does not apply to any of the other four banks involved in the original settlement.  It would allow BOA to avoid paying $350 million in penalties and the back half of the $1 billion FHA claim referenced above.  If, as it appears, the $350 million is the portion of the $2.25 billion which is also structured as a back-end payment it would seem that the bank is being proactive in concluding remaining details of the settlement.  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. BOA will also reduce balances on loans it owns.

The Journal said that the new arrangement is likely to generate criticism from investors who own the securities backed by the mortgages that would be reduced and fund managers who feel it is unfair for banks which were servicing loans for investors to use those loans to settle problems they themselves caused  It quoted one fund director who would not speak directly about the agreement as saying, "To ask investors to pay for banks' fines in any form seems inappropriate and incorrect-we have very serious issues with that."

An Obama administration official however said that principal reductions will be done only when there is a benefit to investors; that is the principal reduction would cost less than a foreclosure, and the reduction would be done in compliance with investor contracts.