Acccording to people familiar with the situation, officials from Bank of America Corp., J.P. Morgan Chase & Co., Wells Fargo & Co., Citigroup Inc. and Ally Financial Inc.'s GMAC unit have been summoned to Washington for a Wednesday meeting with state attorneys general and at least three U.S. agencies.
It will be the first faceoff since the five companies, the largest home-loan servicers in the U.S., got a 27-page "term sheet" earlier this month from state attorneys general that would require the servicers to consider more borrowers for principal write-downs.
In addition, some of the financial penalties resulting from any settlement are "very likely" to be used for reductions in loan balances for certain borrowers, said Iowa Attorney General Tom Miller, who is spearheading the 50-state investigation. Even among state officials, there are disagreements as to whether shrinking loan balances is a good idea.
The "term sheet's principal reduction proposals may actually foster an unintended 'moral hazard' that rewards those who simply choose not to pay their mortgage," the Florida, South Carolina, Texas and Virginia attorney generals wrote in a March 22 letter to Mr. Miller.
The chief executives of Bank of America and Wells Fargo have questioned the fairness of writing down loans, while claiming the costs could be enormous if widespread principal reductions are triggered by a settlement.
Speculation that "we want everybody 'underwater' to receive a principal reduction is not true," Mr. Miller said in an interview, though lopping off thousands of dollars from what a borrower owes on a mortgage "has been underutilized as a tool." An underwater borrower is one who owes more on a property than it is worth.
This month's proposal by state attorneys general would require banks to reduce loan balances for some borrowers if a modification that includes a principal reduction would provide a better long-term return than foreclosure or a loan modification that simply cuts the borrower's interest rate or extends the loan's life.
Loan balances would be trimmed over a three-year period, but only if borrowers made steady payments.
Some loan servicers under investigation by state and federal officials already are slicing loan balances on a very narrow basis. In 2009 and 2010, Wells Fargo forgave a total of $3.8 billion in principal—or an average of $51,000 per loan—for roughly 73,000 borrowers whose mortgages are owned by the San Francisco bank.
Bank of America, based in Charlotte, N.C., had offered loan modifications to more than 127,000 borrowers as of December as part of its previous settlement with state attorneys general over alleged predatory lending by Countrywide Financial Corp., which it bought in 2008. An estimated 35,000 of those offers included a principal reduction.
Officials at Bank of America and Wells Fargo said the two banks are comfortable reducing loan balances for certain borrowers, but oppose broad-based cuts. One reason: Some borrowers could stop making payments to get their debt reduced.
A recent study by Columbia University economists concluded that Countrywide's relative delinquency rate "increased substantially...during the months immediately after the public announcement" of the 2008 settlement.
"It's certainly something to be worried about, but you can't point to this and say, 'Well, we can't do any modifications,' " said Christopher J. Mayer, one of the study's authors.
Most loan-modification programs have focused on temporarily reducing interest rates and extending loan terms.
Principal reductions have gotten more attention recently because so many borrowers owe more than their homes are worth.
At the end of 2010, nearly 11.1 million borrowers, or nearly 23.1% of those with mortgages, were underwater, according to CoreLogic Inc. The tepid nature of the housing recovery suggests many borrowers could remain underwater for years.
Supporters of principal reduction say borrowers who receive such cuts are less likely to redefault.
"Principal write-downs are much more likely to create a loan that is sustainable over the long-term," said Massachusetts Attorney General Martha Coakley, who has made principal reductions a component of four predatory lending settlements.
A study last year by the Federal Reserve Bank of New York found that loan modifications with principal reductions are far more likely to succeed than those that simply reduce interest rates.
According to mortgage servicer Ocwen Financial Corp., 17% of its borrowers who got a principal reduction were behind on their payments again six months later, compared with 20% of those with a modification that reduced payments but not the loan balance.
Over the past year, Ocwen has cut balances on more than 16,000 loans, representing 22% of its modifications.
"We found that it's essential to include principal reduction in our modification arsenal to be able to address the negative equity problem," said Paul Koches, Ocwen executive vice president. In February, Ocwen rolled out a program that will spread principal reductions over three years and let mortgage investors share in any subsequent increase in value when a home is sold.
Some mortgage companies say principal reductions are best used when borrowers are deeply underwater. PennyMac Loan Services LLC will consider reducing principal if the borrower is likely to remain underwater even after three or four years of loan payments, said Steve Bailey, chief servicing officer for PennyMac, which has used principal reduction in 58% of its modifications.