Bank of America Accused Of Putting Itself Before Investors In Mortgage Loan Modifications

Did Bank of America Corp. (NYSE:BAC) merely make a bad decision when it bought Countrywide Financial, the mortgage giant at the center of the subprime mortgage fiasco, or has the second-largest U.S. bank also engaged in sketchy loan-servicing practices?

According to documents submitted late Friday to the New York State Supreme Court in Manhattan, acquired by The New York Times, Bank of America lowered the principal amount owed on first mortgages without also lowering the lines of credit on the second mortgages of the same properties.

What this means is that investors in securities of the first mortgages incurred losses when the bank lowered home-buyers’ obligations. But by keeping the lines of credit on second mortgages unchanged, the court filing claims, Bank of America “may have engaged in self-dealing and other misconduct,” because it put the cost of lowering the chances of borrower defaults onto the backs of real estate investors that held securities in the first mortgages.

Typically the loss works the other way around: The holder of the line of credit is supposed to take the loss before the holder of the first mortgage.

This is not chump change. According to the court filing, Bank of America may have done this type of modification to 134,000 loans worth $32 billion. This is out of a total portfolio of home equity loans owned by the bank worth a staggering $116 billion, according to the bank’s third-quarter 2012 filing with the Securities and Exchange Commission.

The papers were submitted to the court by three of the nation’s 12 Federal Home Loan Banks, the ones located in Chicago, Indianapolis and Boston, and Triaxx, a collateralized debt obligation investment vehicle. Triaxx based its allegations on an analysis of Countrywide-issued securities sold between 2005 and 1007.

What are the implications?

For one thing, a judge could decide that a previous agreement in 2011 to pay out $8.5 billion to investors jilted by Countrywide’s shenanigans may not be adequate to cover all claims linked to 530 Countrywide mortgage securitization trusts. The bank had previously set aside a grand total of $40 billion to settle all claims linked to its $4.1 billion acquisition of the troubled subprime lender in 2008.

For its part the bank denied allegations it passed on losses to investors while protecting its own interests by reducing the changes that borrowers would default on their first mortgages.

“Modifying mortgages for homeowners in severe distress is critical to the ongoing economic recovery and is encouraged by the government at all levels,” Lawrence Grayson, a Bank of America spokesman, told the New York Times. “It is difficult to see how federally regulated entities like the Federal Home Loan Banks would seek to attack that practice which helps families to stay in their homes and in no way violated the contracts at issue.”

But mortgage securities investors have been facing trouble trying to track down abusive loan modifications such as the one Bank of America is being accused of because banks have not been forthcoming in providing detailed information without being sued for that access.