[Update 1: adds additional statements from Anthony Sanders.] A key mortgage modification program facilitated by federal incentives has not only failed to reach the potential envisioned by its founders, but it also has several key flaws that may have destined it for failure from the start, expert witnesses testified to the House Financial Services Committee Tuesday. Home Affordable Modification Program (HAMP), which allocates capped incentives to servicers, lender/investors and borrowers that participate in modification of mortgages at risk of foreclosure, was a large focus of testimony. In an ongoing hearing Tuesday, the House lawmakers are hearing from servicers that testify to early signs of success in HAMP, as well as from community and consumer activist groups and real estate industry veterans that point toward HAMP's key flaws and recommend long-term solutions. Amherst Securities' Laurie Goodman, for example, warns critical shortcomings of HAMP include the program's failure to address negative equity and its lack of effort toward principal reductions. Julia Gordon, senior policy counsel at the Center for Responsible Lending (CRL), summed up ongoing complaints when she said "HAMP has not reached its potential" in opening remarks. Lenders and investors may not agree to accept modifications, as they take immediate financial hits. But capital issues aren't the only deterrent to pursuing modifications. In order to facilitate lasting loan modifications, banks must be allowed to gradually write-off losses and the private sector must be allowed to help modifications, according to Anthony Sanders, professor of real estate finance at George Mason University. "To provide an incentive for financial institutions/investors to sell their distressed mortgage loans to the private markets, the government regulators, including the SEC, should allow financial institutions/investors to amortize the losses for up to 5 years to spread the accounting consequence of a loss over time," Sanders said in prepared remarks (available to download here). He added: "This would enable the financial institutions/investors to sell distressed assets from their books and free up funds to be invested elsewhere such as loans to small businesses." But HAMP keeps loans with lenders, holding up capital on the banks' books and preventing the funds from being used for other loans. Sanders recommended helping financial institutions clean up balance sheets rather than imposing judicial interventions into the mortgage market. Laurie Goodman, senior managing director at Amherst Securities, pointed toward the key role negative equity plays in predicting default behavior. HAMP is "destined to fail," as it does not address negative equity, Goodman said in opening remarks (available to download here). Federal mortgage programs must include principal reduction and must address the loss allocation among first lien investors and second lien investors to have lasting effect. "HAMP has three fatal flaws," she said. "First the agent retained to make the modification was a mortgage servicer rather than an originator. This created a significant amount of ramp time as many servicers were not equipped to handle the many functions necessary to underwrite a modification." Goodman added: "Second, HAMP only considers the first mortgage payment, taxes and insurance. It does not consider the borrower's total financial circumstances. Third, and most importantly, the program does not emphasize the re-equification of the borrower." She emphasized greater importance on principal reduction -- eyed recently by the Federal Deposit Insurance Corp. in lieu of principal forbearance. Goodman says investors will "absolutely" support principal reduction, as foreclosure is costly not only to borrowers, lenders and investors. She suggested banks holding second liens to first write down liens to allow for modifications. Goodman also urged a revamp of Hope for Homeowners to address second liens and misalignment of interests. More transparency on mortgage workout data is also crucial to the success of any program, she added. Write to Diana Golobay.