Bank of America (BAC: 7.29 -0.14%) will consider principal forgiveness before an interest rate reduction when modifying some mortgages for its National Homeownership Retention Program (NHRP).

New changes to the NHRP allow certain subprime, Pay-Option and prime two-year hybrid mortgages to qualify for principal forgiveness to bring severely underwater loans closer to the surface.

With the changes, BofA will look at reducing the principal of a mortgage before reducing the interest rate when modifying a loan under the Home Affordable Modification Program (HAMP).

BofA currently holds more than 1m HAMP-eligible loans in its portfolio, according to the US Treasury Department, and through February conducted more than 20,000 permanent modifications, the second most of any participating servicer. All 113 servicers provided a total of 170,000 permanent modifications.

Under HAMP, servicers attempt to reduce the monthly mortgage payment ratio to less than 31% of the verified income. To do that, they run the loan through a waterfall of modification steps, which include an interest rate reduction, a term extension, then principal forbearance.

BofA expects to implement principal reduction into the modification waterfall by June 2010 as the bank searches for eligible mortgages and contacts qualifying borrowers. The loans must be at least 60 days delinquent and have a loan-to-value ratio of 120% or higher.

BofA estimates that will be able to offer the principal reductions to 45,000 of its borrowers who qualify for a HAMP modification.

The Commonwealth of Massachusetts worked with BofA to design the new changes and became the 44th state to join the NHRP. BofA launched the program in 2008 to provide assistance to Countrywide borrowers who received subprime and Pay-Option adjustable rate mortgages (ARMs).

Write to Jon Prior.

Shari Nott, formerly the vice president of operations at First American and long-time executive in the property preservation industry, recently started National Field Network (NFN), a boutique field-servicing firm built to manage properties from default to disposition.

Nott said NFN can reach out to the borrower with a “kid-glove” approach that increases the chances of a quicker resolution, whether that is a modified loan or liquidation of the property. The United States is now on par with other markets in terms of wringing better returns when cashing in troubled assets.

The increased performance is a result of more attention from private investors wanting to buy-up the distressed properties.

“The after-effect of the sub-prime blow up is that a new secondary market has emerged that seeks pools of distressed, below-value properties to rejuvenate and sell at a profit,” said Nott. “Because of National Field Network’ ability to customize workflow processes to the needs of the client, we cater to the very unique business goals of this secondary market.”

In addition to her work at First American, Nott was the chief operating officer at Ward Associates and vice president of operations for Cenlar. At NFN, Nott assembled a team of managers  with an average of 20 years experience in the industry.

“The industry is fluid right now,” said Nott. “[B]usiness conditions are rapidly changing, insurance rules dictate certain actions in specific periods of times, and business objectives vary. The magnitude of assets to manage is just overwhelming and there is no ‘one-size-fits-all’ solution.”

Write to Jon Prior.

The watchdog on the federal bailout efforts came down hard on the Treasury Department in its latest audit of the program, in particular criticizing the high risk of re-default within the Home Affordable Modification Program (HAMP).

So far, HAMP results have been "disappointing" as, a year into the program, only 168,708 modifications became permanent out of more than 1m trials, according to audit report by Neil Barofsky, the Special Inspector General for the Troubled Asset Relief Program.

Significant risks of re-default remain among even the permanent modifications, and the Treasury's management and expectations of the program lack transparency, according to the report e-mailed to HousingWire.

When the program began a year ago, Treasury officials estimated 3-4m borrowers would receive help under HAMP. It was unclear whether this goal represented trial modifications offered, started or transferred into permanent status.

During the audit process, SIGTARP said a Treasury official estimated 3m borrowers will enter trial modifications through the life of the four-year program, and 1.5m to 2m will convert to permanent status. SIGTARP noted this "may only be a small fraction" of the volume of foreclosures that will occur over the same time.

The pace of HAMP modifications has failed to meet expectations so far, with the rate of growth in trial modifications leveling out in recent months and permanent modifications lagging far behind:

HAMP has disappointed in part because program rules were not defined at the start of the program and the Treasury as a result repeatedly revised the program, causing delay and confusion among servicers, the report claims. SIGTARP also noted the freedom of servicers to begin trial modifications before receiving supporting documentation proved "counterproductive" as many of the trials will never become permanent. Additionally, the Treasury's marketing of the program remains "limited" even a year after the program began.

The risk of borrowers re-defaulting even after permanent modification status remains high within HAMP. The element of HAMP's design chiefly responsible for this is the fact a borrower's non-mortgage debts are not considered when modifying mortgage payments to within 31% debt-to-income.

SIGTARP also noted that, under a HAMP modification, the interest rate is set to adjust after the five-year modification period. If the interest rate rises but the borrower's income does not, for example, the re-default risk is high.

Second liens also present significant risk to the performance of modified first liens, as monthly payments might still be unaffordable if the second lien is not modified or extinguished, SIGTARP said. Treasury recently began signing the first servicers to the Second Lien Modification Program (2MP), with Bank of America (BAC: 7.29 -0.14%), Wells Fargo (WFC: 29.60 +1.89%) and JP Morgan Chase (JPM: 37.21 -0.75%).

SIGTARP also pointed to the prevalence of negative equity in mortgages eligible for modification: "[R]e-defaults resulting from negative equity, including strategic defaults, may be a factor as borrowers decide that it makes more economic sense for them to walk away from their mortgages notwithstanding the lower payments."

The report recommends the Treasury disclose goals for how many borrowers "will actually be helped" with permanent modifications and set goals for performance under the modifications. also recommended launching a public service announcement campaign to increase awareness of HAMP.

SIGTARP said Treasury concurred with these suggestions, but "non-concurred" with the last two, that the Treasury should reconsider its decision to allow servicers to substitute alternative forms of income verification, and should re-examine HAMP's structure to minimize the risk of re-default.

Write to Diana Golobay.

Disclosure: The author holds no relevant investment positions.