Proposals from a coalition led by Fortress Investment Group address the problem of "underwater" loans, whose high balances relative to fallen home values have to many investors become the chief threat to U.S. housing stability.

Central to plans pitched this week to U.S. House Financial Services Committee Chairman Barney Frank is a controversial way to deal with secondary loans that homeowners piled on during the housing boom. These home equity loans are a major hurdle in modifications, being attached to more than half the mortgages in private mortgage bonds, according to Amherst Securities.

The Mortgage Investors Coalition -- which represents holders of some $100 billion in mortgage bonds -- instead of demanding full write-downs on second liens are prepared to consider a principal reduction plan where losses are shared, said Micah Green, an attorney representing the group. This softened position on second liens could help break the impasse keeping big bank servicers from forgiving principal, he said.

"There is a growing sense of concern among policymakers that the lack of homeowner equity is really getting in the way of providing a solution to homeowners," said Green of Washington law firm Patton Boggs LLP.

The coalition proposal follows U.S. Senate leader Harry Reid's request of Treasury and housing officials for a "more aggressive" principal forgiveness component to the U.S. government's Home Affordable Modification Program, which has been dogged by difficulties in completing modifications and signs that many borrowers are defaulting even after payments were cut.

The Treasury is considering ideas to address the problem of underwater loans, an official said.

Principal reduction could be "a natural evolution" for HAMP, which attempts to make mortgages affordable through lower interest rates or forbearance, Green said. Investors want it because they, like homeowners, are in bad loans, he said.

Under the coalition plan, investors would forgive principal to 96.5 percent of homes' value, clearing a path for borrowers to refinance into a federally backed mortgage.

The urgency to deal with underwater loans -- estimated at nearly 30 percent of all mortgages -- has been gaining steam amid signs that borrowers are choosing to default even if they can afford the mortgage. Some 10 million loans that are at least 115 percent of the property's value are at risk of such "strategic defaults," the coalition said in a letter to Frank.

If a principal reduction HAMP were offered, the Treasury could limit moral hazard by limiting eligibility to homeowners already in arrears, the coalition said.

But investors are still sharply divided over how to modify loans, analysts said.

At risk is the sanctity of legal contracts, which typically require second-lien investors to take a full loss before firsts are hit. While that understanding is "defendable and correct," it may also be impractical, the coalition said.

"The objective of creating a serious capability of getting in front of the foreclosure debacle is somewhat idealistic, but we have to turn the idealistic into the pragmatic," said Louis Lucido, a principal at Los Angeles-based investor DoubleLine.

"What we don't want to do is take contract law and turn it upside down," said Lucido, who supports the coalition's plan.

BlackRock Inc., the largest institutional bond manager, has floated another idea that cuts second-liens and other debts that are keeping homeowners from paying their mortgages. It wants modifications done by courts, which could be told to reduce a borrower's debt in order of seniority as is done in corporate cases, according to a recent research note.

Both proposals aim to solve what investors say is a conflict of interest at Bank of America and three other big banks that hold $452 billion in second-liens -- and service and modify first liens. By modifying a first and not the second, the subordinate piece is improved at the first's expense, investors said.

The banks also hold $231 billion in credit card receivables, which, under BlackRock's plan, would be written-down before the primary mortgage is affected.

"A solution must be found to write down the second-lien without impairing the capital position of the four largest financial institutions," Laurie Goodman, a strategist at Amherst, said in a report last week