Under the arrangement, part of the recent $25 billion settlement of alleged foreclosure abuses between government officials and five large lenders, Bank of America will make deeper and broader cuts in balances than other banks

The plan will offer qualifying borrowers a chance to cut their mortgage balances to their home’s current market value. Other banks are required under the national settlement to cut principal to no more than 120% of the home’s value.

Borrowers who qualify are expected to receive principal reductions averaging more than $100,000, a Bank of America spokesman said. The pact’s total value will depend on how many borrowers take up the offer.

Based on the 200,000+ homeowners the article cites as being eligible for this action, a little simple math puts the total principal writedowns by BofA at over $20 billion! Now that seems like an even more unbelievable number than the $100,000 per household.

Of course, per the report, this will allow BofA to avoid $850 million in fines and they’ll save a bundle in taxes by adjusting these mortgage balances down, many of which they’d end up taking back as foreclosures anyway.

I guess homeowners are finally getting their bailout too!

Of course, the more important story is what’s been happening lately and, though there has been some overall improvement, conditions are not much better than they were at the height of the housing and credit market crisis a few years ago, the growth of the “Recently cured expected to redefault” category not being a particularly encouraging sign.

RealtyTrac released its final report on foreclosure activity in 2011 noting that distressed sales accounted for 24 percent of all sales in the fourth quarter, up from 20 percent in the third quarter, and that the average price of a foreclosure-related sale was 29 percent below non-foreclosure sales. Corelogic reported the latest data on negative equity below, a situation that is not likely to get any better with ongoing home price declines.

With nearly a third of all borrowers either in or near negative equity, we’ll be hearing a lot more on this subject during this election year as the banks’ foreclosure mills crank up again along with talk of (and a little action on) principal writedowns.

Property values fell in 18 of the 20 regions in the index as Phoenix and Miami – two areas hit particularly hard during the bursting of the housing bubble – posted modest advances. Detroit led all declining regions with a drop of 3.8 percent in December, followed by Chicago and Atlanta where prices were down 2.0 percent and 1.8 percent, respectively.

On a seasonally adjusted basis, the 10-city and 20-city indexes fell only 0.5 percent to close out 2011, their sixth straight monthly decline, and both indexes indicated that home prices were down four percent for the year.

David M. Blitzer, Chairman of the Index Committee at S&P Indices noted the following:

While we thought we saw some signs of stabilization in the middle of 2011, it appears that neither the economy nor consumer confidence was strong enough to move the market in a positive direction as the year ended. After a prior three years of accelerated decline, the past two years has been a story of a housing market that is bottoming out but has not yet stabilized. Up until today’s report we had believed the crisis lows for the composites were behind us, with the 10-City Composite originally hitting a low in April 2009 and the 20-City Composite in March 2011. Now it looks like neither was the case, as both hit new record lows in December 2011. The National Composite fell by 3.8% in the fourth quarter alone, and is down 33.8% from its 2nd quarter 2006 peak. It also recorded a new record low.

Here’s the chart showing the new lows using the raw index data:

Mr. Blitzer has clearly not been swayed by all the talk about a housing recovery this year.

The months of supply metric fell from 6.4 months to 6.1 months, the lowest level since the economic recovery began, as overall inventory dropped 0.4 percent to 2.31 million units.

As expected, prices continued their descent during the winter months where the share of purchases by bargain hunting investors grows, the median home price falling 4.6 percent for the month, 2.0 percent lower on a year-over-year basis.

Foreclosures and short sales accounted for 35 percent of all January sales, up from 32 percent the month before, and the share of sales to investors rose from 21 percent in December to 23 percent with all-cash sales unchanged at a 31 percent share.

There are some other interesting charts in there as well, including pie charts on underwater mortgages, delinquent loans, and properties that have made it all the way through the foreclosure process, along with bank loss data for California properties where, to me, $41K sounded a little low given that average loan amounts were north of $400K.

“If you look at the supply of homes, new construction, and compare it to immigration into the United States, to the growth of the population, then these (southern) markets are very attractive from a longer term perspective,” Faber told Bernie Lo on CNBC’s Straight Talk.

Among the markets he pointed to were Atlanta, Phoenix and Miami. Faber said investors could earn a rental yield of 8 percent per year and buy homes in the south of the U.S. at a 40 to 50 percent discount to construction costs.

Faber said he went to see homes in Phoenix and Atlanta, and in some cases, U.S. homes were cheaper than those in Thailand, where he lives.

At the same time, the fact that people couldn’t get credit to buy homes in the U.S. was helping to boost the rental market, he added.

It is rather remarkable what is happening in a place like Atlanta. According to the latest Case-Shiller home price data, they’ve recently overtaken Cleveland and Phoenix while rapidly closing in on Las Vegas in what is, for some cities, an ongoing race to the bottom. Detroit remains the unquestioned leader in the group, however, extrapolating recent trends would see Atlanta claim that title by the end of the year.

Bullard threw a cat amongst the pigeons in this speech(.pdf) when he noted the following:

The recent recession has given rise to the idea that there is a very large “output gap” in the U.S. The story is that this large output gap is “keeping inflation at bay” and is fodder for keeping nominal interest rates near zero into an indefinite future. If we continue using this interpretation of events, it may be very difficult for the U.S. to ever move off of the zero lower bound on nominal interest rates. This could be a looming disaster for the United States. I want to now turn to argue that the large output gap view may be conceptually inappropriate in the current situation. We may do better to replace it with the notion of a permanent, one-time shock to wealth.

Recall that I’ve railed on this subject a number of occasions over the years, the last time being this offering from about six months ago when it was noted:

The theory posits that it is not important what level of overall demand an economy has reached or how it got there, but that, when all the wheels fall off the wagon as they did back in 2008, the imperative is for the government to somehow restore that level of demand. Otherwise, you get another Great Depression.

It makes no difference if, back in 2005, people making $40,000 a year were buying no money down $500,000 homes and then, after the home’s value went up to $600,000 in 2006, pulling out their $100,000 in brand new home equity to put in a pool, buy a motor home, and install big screen TVs in every room of the house because, once you reach a certain level of demand and it begins to drop like a rock because everyone has become indebted up to their eyeballs, it must be restored.

At that point, it simply becomes a question of how much taxes must be cut or how much money must be borrowed or printed to accomplish that goal.

Of course, I don’t have any models to back up the contention that an unusually large portion of economic output we saw in the middle of the last decade was “artificial” due to the housing bubble, but economists do have models, and that’s the crux of the problem.

As Bullard noted, the models economists use to determine the “potential” of the U.S. economy, in essence, extrapolates from the pre-2007 period to the post housing bubble period and, as a result, you end up with a big gap between potential and actual output that policy makers are now seeking to close by borrowing and printing money on a scale never before witnessed by Mankind.

For those of you preferring pictures to words, the chart below by Neil Irwin from this neat little interactive graphic at the Washington Post might be helpful.

Being more detached from reality than the population at large, economists seem to prefer the idea of debating ways to close the gap that has developed in recent years rather than thinking about whether the output gap even makes sense as Bullard has suggested.

The failure to deal with the real world rather than how that reality is reflected in models and the reluctance to venture outside of their analytical comfort zone to embrace common sense (as Bullard clearly has) have clearly produced yet another example where models – whether they’re good, bad, or indifferent – rule.

Models tell economists one thing, but common sense tells the rest of us something very different about what is going on here.

I’d go so far as to argue that the output gap theory is about the absolute worst way to think about an economy because the means become unimportant relative to the end – and that’s a very dangerous policy for an economy such as ours, prone as it is to asset bubbles.

Though few economists would read it this way, non-economists might argue that the chart above shows how the small output gap created by the bursting of the internet bubble was addressed under the Greenspan Fed by creating a housing bubble that has now left behind an even bigger output gap.

And this explains why we didn’t see big excesses in the economic data five or six years ago – because all our bubble economy was doing at the time was pushing output back to its “potential” from the 1990s that was also artificial, that is, to the extent that companies like Pets.com aren’t around anymore.

To a growing number of observers like Bullard, it appears that policy makers could now be in the process of creating an even bigger and more destructive asset bubble to close the current output gap, not considering the possibility that what they’re really doing is  trying to artificially boost demand yet again to have it meet up with a level of potential that is now even more artificial than when the internet bubble burst.

A list of links are included below for anyone wanting to pursue this further. One can be hopeful that there are individuals like Bullard who are asking tough questions about what passes for conventional wisdom amongst the dismal set, but his self characterization of being “an army of one” doesn’t bode well for the future.

What output gap? – MacroManiac
Jim Bullard chucks the Solow growth model!- Noahpinion
Bubbles and Economic Potential – Krugman
A loss in wealth should boost economic growth – The Money Illusion
The trend is your friend (until it ends) – MacroManiac
It’s Worse Than You Think – Fed Watch
Bullard On Duy On Bullard On Potential Output – Econospeak
James Bullard Responds to Tim Duy – Economist’s View
Again With Potential Output – Fed Watch

A ‘deadbeat’ bailout – NY Sun
The Mortgage Deal: A Reality Check – NPR
Mortgage deal: What the critics say – CNN/Money
U.S. banks agree to $25 billion in homeowner help – Reuters
Settlement launches foreclosure reckoning – Washington Post
Why the Foreclosure Deal May Not Be So Hot After All – Taibblog
Why Millions Won’t Get Help From Big Mortgage Settlement – ProPublica
Top Twelve Reasons Why You Should Hate the Mortgage Settlement – Naked Capitalism
Foreclosure Settlement Falls Short, Still Worth the Wait: View – Bloomberg
Is The Foreclosure Settlement A Shadow Bailout For Broke California – Zero Hedge
What the foreclosure settlement means for you – CNN/Money
Mortgage Settlement and Negative Equity – Calculated Risk
Robo-Deal Is All About Lowering Mortgage Principal – CNBC
Banks Not Off Hook With $25B Mortgage Agreement – Bloomberg
Mortgage Plan Gives Billions to Homeowners, but With Exceptions – NY Times
Florida Homeowners Find Little to Cheer in Deal With ‘Gangsters’ – Bloomberg
Mortgage Deal Props Up California House of Cards – Bloomberg
Cramer: This Mortgage Settlement Is Huge – The Street
Foreclosure Deal to Spur U.S. Home Seizures – Bloomberg
The Mortgage Settlement Is Fine – DealBreaker

I’d be lying if I said I’d read all of these (or more than a couple for that matter), but I intend to take a look here this morning. Just based on the headlines, it would appear that the deal is getting a mixed reaction.

Says Stockman:

This is ultimately, at the end of the day, a bailout for JP Morgan and Wells Fargo. They’re the big writers of second mortgages and home equity lines. Those – and there’s two or three or four hundred billion dollars in the top three or four banks – are in great jeopardy in the case of of homeowners who have mortgages, that are primary mortgages, that are way under water on primary mortgages and are likely to default or throw in the keys at some point down the road.

Good point…