Principal reductions stemming from the state attorneys general agreement with mortgage servicers could disrupt payment on performing mortgages, eliminating gains expected from the initiative, Fitch Ratings said Thursday.

Analysts said the result of not implementing the program carefully will be "a wide-ranging principal reduction program" that could "potentially increase defaults among borrowers who would otherwise remain current."

Fitch says more than 75% of prime borrowers with loan-to-value ratios of 125% or higher are still current on their mortgages.

And when it comes to Alt-A and subprime borrowers, a little more than half of those underwater still remain current.

These numbers show a strong willingness among underwater borrowers to pay their mortgages, making it risky to unevenly roll out principal write-downs, according to Fitch.

Otherwise performing mortgage borrowers may consider a default to qualify for the principal reduction, the analysts suggest. Another risk is that re-defaults on loans that experience deep balance cuts remain above 20%.

"Most mortgage re-defaults arise from borrowers being sizably weighed down with non-mortgage debt after their loan has already been modified," the analysts said.

"To make the mod payment sustainable, servicers may begin using back-end debt ratios to determine the principal balance cut," according to Fitch. "Such an action may effectively force the first-lien investor to subsidize the repayment of the borrower’s consumer debt, thus increasing the potential incidence of defaults among over-leveraged or marginally underwater borrowers looking to qualify for such a reduction."

Analysts said a targeted plan that determines borrower principal reduction eligibility on payment-to-income ratio levels would help keep at-risk borrowers afloat without increasing the moral hazard risks.

As for investors in residential mortgage-backed securities, Fitch said the costs they will pay is contingent on "the allocation of the reductions between the first and second lien holders" and the application of reduction credits between the banks owned portfolio and private-label RMBS.

If that process is not handled in a way that gives investors confidence, Fitch said the write-downs could kill investor confidence, making it more difficult to kickstart private-label RMBS with capital from mortgage investors.

kpanchuk@housingwire.com