Bank of America is the first major issuer of mortgage loans to announce that it is implementing a new loan balance reduction program that will help homeowners who are underwater on their mortgages. The $3 billion national program will begin looking at, and possibly reducing, up to 30% of the mortgage balances and after that it may also lower the interest rates of some mortgages to reduce monthly payment amounts for homeowners.

By offering these reduction Bank of America is hoping that its borrowers won’t just walk away from their houses when their mortgages are underwater and allowed them to be foreclosed on. A reduction in balance will initially hurt Bank of America’s potential profits, but foreclosures hurt it even more, so they are experimenting with this program to see if it will keep people in their homes (and paying their mortgages).

But B of A is not quite the superhero that everyone is making them out to be. The program will look at subprime, prime and high-risk borrowers who initially worked with Countrywide Financial Corp. which Bank of America bought in 2008. Many of the modifications will probably be done to Adjustable Rate Mortgages (ARMS) that were issued three or four years ago. The bank will look for people who are paying mortgage on homes that are at least 20% higher than their home’s value and have some sort of proof of hardship like a lost job or illness. Even Bank of America officials only expect that the program will help about 45,000 of their over 1 million customers across the nation.

After the announcement lot of homeowners started asking how to apply to the Bank of America home loan reduction program, but that’s where things get difficult: you can be enrolled in this experimental program by invitation only. There basically is no application process with B of A to get your home loan balance reduced at this point.

Here’s how the program works: Suppose you are making mortgage payments on your $200,000 mortgage but your home is only worth $150,000 now. Bank of America could work with you to set up your loan payments to be based off the $150,000 amount, not the original $200,000 mortgage amount. After five years your mortgage could be modified to stay that way.

There’s another catch, though. If home values recover in the fourth and fifth years of the loan modification then the balance of the loan would only be reduced to the current home value, which could be back up to $175,000 or more. This was done so that investors in the Bank of America may not lose as much money as if they’d just written off the $50,000 from the mortgage. Those mortgage payments are how investors and the bank makes its money and profit.

The program would not just erase part of the balance on the mortgage. Instead, it would implement a “forbearance” program which would allow homeowners to skip paying part of the interest owed over a five-year period. If the homeowner stayed in the home for five years and kept up with the reduced payments then the interest payments that were skipped would actually be forgiven.

Bank of America is hoping this will give people incentive to stay in their home and, again, continue paying their mortgage payments.

The idea of modifying home loans to help homeowners who are underwater on their mortgages is not a new concept, but it’s one which few banks have liked before. Most of the government’s programs (like the recent making Homes Affordable Program – HAMP) have tried to reduce interest rates, but this is the first big program to actually reduce the balance owed on a loan.

The program appears to be part of a class-action lawsuit brought about by consumer advocates in Massachusetts. Bank of America has other class-action lawsuits pending against it in other states, and lawyers in Massachusetts are also looking at other large lenders in the state. Even normally bullish investors have been thinking that banks should be looking at more aggressive ways of solving the housing problem because if enough people walk away from their homes then the banks will have an even bigger problem: they’ll own thousands of homes that are essentially unsellable and worthless.