Bank of America says they have begun mailing notices to their borrowers about principal reduction opportunities under the foreclosure fraud settlement. You may recall that BofA inked a side deal on the settlement that would allow them to extinguish an additional $850 million of the cash penalties by reducing loan balances more deeply than called for in the settlement. At the time it was announced, the thinking was that BofA could avoid that $850 million by reducing balances on loans it didn’t actually own.

The expanded program could allow Bank of America to avoid paying $350 million in penalties tied to the foreclosure settlement and half of a separate $1 billion penalty related to a settlement of false claims filed on loans backed by the Federal Housing Administration, if the bank meets certain targets. 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. BofA will also reduce balances on loans it owns [...]

Some fund managers feel it is unfair for banks, which serviced mortgages on behalf of investors, to use those same loans to meet their obligations under the settlement. “The fact that a servicer has done a poor job has already impacted borrowers and our investors,” said BlackRock Managing Director Randy Robertson, who declined to speak specifically about the Bank of America agreement. “To ask investors to pay for banks’ fines in any form seems inappropriate and incorrect—we have very serious issues with that.”

So whom did BofA reach out to today?

The bank said it planned to contact more than 200,000 homeowners who could be candidates for the offers, sending letters to a majority of them by the third quarter of this year.

To be eligible for the principal reductions, however, homeowners will have to meet certain criteria, including: having a loan owned or serviced by Bank of America; owing more on the mortgage than their property is worth; and being at least 60 days behind on payments as of the end of January.

Owned OR serviced. In other words, this is exactly as we suspected; BofA will try to extinguish cash penalties by modifying principal on loans they service but don’t own. And they’re trying to load up on the modifications with those loans.

Earlier the bank said that the average principal reduction would be in the range of $100,000. According to their new statement, the reductions could average as high as $150,000. That means that, one, fewer borrowers will benefit, for it takes fewer borrowers at an average of $150,000 to reach their target number; and two, they’re probably trying to load up on more homes where the loan isn’t owned by them, reducing lots of principal on those homes. These are probably late-bubble models that Countrywide appraised way too high, where bringing down to market value costs a ton of money. They’ll pick and choose the special cases and “pay” their debt to the government with someone else’s money.

I’m generally happy to see any principal reduction happening, though of course these are letters and not actual principal reductions. BofA sent out the letters to 200,000 borrowers, and now they can pick and choose on whom to bestow these benefits. And additionally, BofA will build in a three-month trial period where borrowers will have to pay the mortgage at the new rate. This was the trap in HAMP, as borrowers didn’t get an answer on a permanent modification after three months, waited, and were then hit with a denial and a demand for the difference between the trial payments and the original mortgage within days to avoid foreclosure. Looks like BofA may be setting the same trap.

To call this a “penalty” for these banks, or a first step or a down payment or whatever it is Shaun Donovan is calling it these days, should only provoke laughter.