The Wall Street Journal “Bank of America in Settlement Worth Over $8 Billion” (online) and “Bank of America Settles Countrywide Suit” (print) report that Bank of America (BAC) settled with the attorneys general in multiple states regarding risky loan practices. Up 390K subprime mortgage borrowers could have their loans modified so that their payment won’t exceed 34% of their income. These modifications could “cost” more than $8.6B to Bank of America and investors who purchased securities composed of Countrywide mortgages. The reality is that the savings will probably be much greater than the cost.

The attorneys general called Countrywide’s practices predatory lending. The mandatory modifications include: principal reductions to facilitate refinancing to government backed loans and reducing interest rates to as low as 2.5%. The negative amortization in option ARMs will be removed and prepayment penalties eliminated. Investors might have to approve certain modifications to mortgages held in securitizations.

The settlement could actually be of great benefit to Bank of America and become a model for other banks. Both Washington Mutual (WM) and Wachovia (WB) claimed to be moving in this direction, but were so lethargic that they imploded before they could show any results. Merrill Lynch (MER) on the other hand simply dumped the bad stuff, leaving others to sort through the mess. I don’t know whether WaMu and Wachovia could have remained independent if they preemptively modified all of their option ARMs, but I think the chances would have been much better.

Bank of America is being forced to create value from junk. Loans which are current and accruing are far more valuable than loans in default or hopelessly loaded with negative amortization. The biggest impediment to other banks following suit is the effect that further write downs will have on their capital requirements. The illusion of maintaining negative amortization was completely erased when JP Morgan (JPM) aggressively wrote down WaMu’s option ARMs in the takeover.

To the distain of many conservatives, the activist judicial system is doing the job that banks and their regulators have neglected. Eventually, all mortgages will have to match the ability of their borrowers to pay. In a dead real estate market, foreclosure is rarely more profitable than loan modifications. Even though Congress was unsuccessful in allowing bankruptcy judges to modify mortgages, it looks like the courts still have the power to initiate change.

Disclosure: Author is long multiple financial institutions.