Banks can be liable for $20 billion in civil fines, or to fund a comparable amount, for loan modifications of distressed borrowers. This will serve as a settlement for alleged mortgage servicing breakdowns, according to WSJ report today.

Terms of the administration's proposal include a commitment from mortgage servicers to reduce the loan balances of troubled borrowers who owe more than their homes are worth, people familiar with the matter said. The funds could be used to pay for these reductions in loan principal. However, it remains unclear who will be eligible for these principal reductions.

"Since the beginning of the housing crisis, we think that moral hazard cost has been the core issue and challenge related to principal reduction," reported analysts at Bank of America Merrill Lynch in a report today. "We believe that a $20 billion levy on banks to fund principal reduction would bring with it enormous costs that would far outweigh any potential benefits. "

According to BofA Merrill analysts, the levy could lead to further restricting mortgage credit availability and, as a result, could hinder housing recovery, and force the government to assume an even larger role in housing finance than its current 94% share.

This scenario is the opposite of what the recently-released Housing Finance reform proposals issued earlier this month are aiming to accomplish.

"The core issue raised here is recourse and the right to foreclose,"  said BofA Merrill analysts. "Banks face penalties that appear to be disproportionate to the infraction. There is a simple way for banks to manage this tail risk: namely stopping mortgage lending, which clearly would be an unacceptable outcome."

The $20 billion would also do little in terms of addressing aggregate negative equity, which CoreLogic estimated at $744 billion because banks tightening of private credit availability  could accelerate the downward momentum in home prices. BofA Merrill analysts said that in such a scenario, "$744 billion of negative equity could easily grow to over $1 trillion or even higher."

"In our view, this proposal would re-open the property question and create somewhat unquantifiable tail risk to the downside for home prices," said BofA Merrill analysts. "The reason we believe this forced levy would result in credit tightening is that we think banks would immediately recognize that they have to incorporate the risk of future levies into the pricing of mortgage credit."

 

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