The behavioral psychology here is very easy to understand. No bank wants to admit that it wrote idiotic loans, and write down its own assets from par. Meanwhile, it’s much easier to write up an acquired asset, if the amount you reduce the loan is less than the discount you bought the loan for in the first place.
Economically speaking, however, what the banks are doing here does not make sense. Either writing down option-ARM loans makes sense, from a P&L perspective, or it doesn’t. If it does, then the banks should do so on all their toxic loans, not just the ones they bought at a discount. And if it doesn’t, then they shouldn’t be doing so at all.
If a bank has a loan on its books valued at par, and it offers a principal reduction, it must write down the value of the loan. It takes a hit against its capital position, and experiences an event of nonperformance that even the most sympathetic regulators will have no choice but to tabulate. If a bank has purchased a loan at a discount, however, the loan is on the books at historical cost. The bank can offer a principal reduction down to the discounted value without experiencing any loss of book equity.
Of course this is a matter of mere accounting. Whether or not a bank takes a capital hit has no bearing on whether a principal reduction will increase the realizable cash-flow value of the loan.
This moves the problem one layer further back: What is the rationale for these accounting rules? Either a principal reduction should be discouraged via accounting convention whether the loan was purchased or bought or it should be allowed in the right circumstances…
(Hat tip: Mallesh Pai)