There’s been a lot of back and forth in the analyst community about the proposed foreclosure fraud settlement. Here’s some more forth, in fact, from Adam Levitin, who says that many of the reiterations in the term sheet bring violations under the jurisdiction of the CFPB and state AGs, even in non-judicial foreclosure states, which expands who can bring charges.

Until today, we didn’t know how the banking industry would react, although we could guess. And now, Bank of America has become the first to reject the idea.

Showing resistance for the first time against government pressure to write off tens of billions worth of mortgage debt, Bank of America executives said on Tuesday that the idea was unworkable and warned that it would be unfair to borrowers who had managed to stay current on their loans.

“There’s a core problem that if you start to help certain people and don’t help other people, it’s going to be very hard to explain the difference,” said Brian T. Moynihan, the chief executive of Bank of America. “Our duty is to have a fair modification process.” […]

Officials of Bank of America, the nation’s biggest mortgage servicer, argue that any effort to help troubled borrowers should not penalize borrowers who are underwater but have managed to make their monthly payments.

“There may be as much as $1 trillion worth of mortgages that are underwater,” said Terry Laughlin, the Bank of America executive whose unit, Legacy Asset Servicing, handles mortgages that are delinquent or in default. “What do you do for those borrowers that have a job but have negative equity and have paid on time and honored their obligations?”

Indeed there are a staggering amount of borrowers who are underwater – according to CoreLogic it’s 23% of all homeowners. And let’s ask ourselves a question.

Who’s fault is that? Is it the fault of the homeowners, who bought when they needed a home? Or is it the fault of the mortgage industry, which blew up a bubble through corrupt practices and outright fraud, only to see the bubble burst? I’d go with the latter. And given that the settlement should not really be an ask but a punishment for commissions of fraud, ideally BofA wouldn’t be in a position to decide whether to accept it.

And actually, they’re not. Bank of America has a business decision to make. They could deny sustainable modifications for their underwater borrowers, and risk foreclosures that will only bring back less revenue for them in the long run, or they could embark on the correct long-term strategy. And incidentally, they seem to know they’re in long-term trouble.

Bank of America Corp. (BAC), the biggest U.S. lender by assets, is segregating almost half its 13.9 million mortgages into a “bad” bank comprised of its riskiest and worst-performing “legacy” loans, said Terry Laughlin, who is running the new unit.

“We are creating a classic good bank, bad bank structure,” Laughlin told investors at a meeting in New York today. He was promoted last month to manage the costs of resolving disputes stemming from the company’s 2008 purchase of Countrywide Financial Corp. “We’re going to get after this, we’re going to do it the right way and we’re going to put it to bed in the next 36 months,” he said.

The legacy portfolio will hold 6.7 million loans with outstanding principal balance of about $1 trillion, according to a presentation to investors today. The split leaves home loan President Barbara Desoer with about half her previous portfolio, as well as new lending going forward.

Bad banks are typically what you do when you liquidate a financial institution, as Yves Smith explains. The legacy assets are secured and wound down, and the “good bank” gets restructured. But that doesn’t mean this is a first step to winding down BofA; in fact, it may cut off those who have legal claims against the company.

What is striking is the tension between Bank of America saying that this is a measure designed provide more transparency to investors and put dedicated resources on a festering problem to get it resolved versus the specific and loaded terminology they used to describe it, “good bank/bad bank”. Normally, you’d assume that an investor presentation by a big public would be a deliberate affairs. But as Chris Whalen said to me by phone, “I wouldn’t assume that the people at Bank of America are being any more logical than they have ever been. They are just making this up as they go along.” […]

Let’s say the Lilliputians really do continue winning against the banks, and in particular Bank of America, in the courts. Their litigation losses and projected litigation liabilities mount at a faster pace (and that could happen even more quickly if investors decide to sue).

The FSOC tells Bank of America to put the legacy assets in a separate legal entity. Using its Star Chamber powers, it seizes the bank (either the entire bank, immediately spinning out the rest, or just the bad bank, the niceties of how you’d execute this maneuver are above my pay grade).

The powers that be then by fiat treat all the mortgage-related claims as liabilities of the bad bank. That bank has very little in the way of assets, so those creditors get paid a fraction of the value of their claims. Since this mechanism is beyond legal review, the creditors would be stuck with a fait accompli. They’d have no way of getting recoveries from other bank assets (the notion being that every penny paid in dividends and bonuses since the Countrywide acquisition really belonged to the bank’s creditors and claimants, so recoveries from the bank as a whole are fully warranted).

Bank of America described their resistance to principal mods yesterday as a moral hazard issue; they don’t want to encourage borrowers to default on their loans and get a modification. But what could be a bigger moral hazard than a bank manipulating the resolution process to screw their own creditors?

David Dayen

David Dayen