Martin Andelman, the founder of the Mortgage Lender Implode-O-Meter, has a pretty good explanation as to what is going on.

Basically, it comes down to the games that bankers play.

With the Federal Accounting Standards Board (FASB) backing down on reality based accounting of banks (here for background), it means that banks are continuing to account for these mortgages at full face value, but would have to write down these assets if they renegotiated the loan:

Why would a bank chose to foreclose and evict when there’s already someone living in the house who would love to buy it. By modifying the loan, the bank won’t have to pay all the associated costs of foreclosure, and then put the property on the market where it might not sell for some time. Selling an REO? Lucky to get 50% in some areas. Why not just write down the loan for the homeowner and save all the trouble? Again, it makes no sense.

Until I went back and thought about the partial suspension of the accounting regulations imposed under FAS 157 & 159, which applies only to banks and only as of last April or May, I believe. That’s when I started feeling queasy.

Under the partial suspension of the FSAB accounting rules, the banks don’t have to write down Level 3 [an asset without a regular market] assets to market value, if they state that the bank has no plans to sell the assets for an extended period. In other words, if the bank says that it’s not going to sell a given house anytime soon, they can keep it on its books at its full fictional value.

If they renegotiate loans, they rapidly become officially insolvent.

Of course, this means that by the standards of the reality based community, they are already insolvent.

As much as it pains me, I think that Andelman is wrong on blaming Timothy “Eddie Haskell” Geithner on this. The FASB set up these rules independently of Treasury, and under pressure from Congress, not from the T-men.