From Businessweek.com:

More than one in five borrowers in the U.S. are underwater; collectively the shortfall is about $751 billion. Nationally, homeowners whose mortgages have been modified without a principal reduction are up to twice as likely to re-default as those with some forgiveness, according to Atlanta-based Ocwen Financial, a subprime servicer that reduced principal in almost 20 percent of its loan modifications in the last year. “The reason so many homeowners give up is because there is absolutely no hope,” says Brent T. White, a law professor at the University of Arizona who studies underwater borrowers. “They want someone to meet them halfway.”

Banks worry that if they reduce principal, the losses they’d have to take would erode capital cushions. Mortgage servicers don’t like principal reductions because they lower the fees they collect and cut into profits. Some Republican lawmakers call the idea a bailout that will encourage more borrowers to default. Mike Trailor, the director of Arizona’s housing finance agency, says that as he tried to get a write-down program going, most banks and servicers told him it would only encourage more defaults. “I learned a new word for ‘no,’ and it’s ‘moral hazard,'” Trailor says.

While House Republicans are moving to end the Home Affordable Modification Program, the Obama Administration’s flagship loan modification effort, the year-old Hardest Hit Fund would not be defunded under the GOP plan. So far the smaller program has awarded $7.6 billion to 18 states.

About 20 percent of the money is going to principal write-downs in nine states, with California, Nevada, and Arizona getting the bulk of it. Nevada and Arizona have signed up Bank of America, and California is in talks to do so.

Brian T. Moynihan, the BofA chief executive officer, told investors at a Mar. 8 conference that the bank resists calls by federal and state officials for nationwide principal write-downs, preferring more targeted efforts. “Our duty is to have a fair modification process,” Moynihan said. The bank was set to announce Mar. 10 a principal forgiveness program for military service members leaving active duty and behind on their mortgages. To have an impact, though, the states must attract other large mortgage servicers.

The three states are trying to avoid helping owners who used their homes as ATMs during the housing boom. All three held focus groups or public hearings to help them define what is a deserving borrower. The programs will only help lower- and middle-class homeowners who can document financial difficulties. They will not trim a loan’s balance all at once. Instead, they forgive some of the principal over three to five years, depending on the state.

Trailor says it took the better part of a year to address BofA’s procedural issues to win its participation. Lisa Joyce, policy and communications manager at Oregon Housing and Communication Services, which is starting one of the nine principal-reduction programs, says the states must take care to design plans so that participants pass “the front-page test.”