Principal write-downs on Fannie Mae and Freddie Mac loans are more likely to become a reality and are less of a moral hazard than some might imagine, according to analysts with investment bank Keefe, Bruyette & Woods (KBW).

In a report published by Bose George, Jade Rahmani and Ryan O'Steen, the research firm concluded that Treasury Secretary Timothy Geithner's testimony in front of Congress last week suggests that the Federal Housing Finance Agency may be reevaluating the position to not force principal reductions on mortgages.

Furthermore, the analysts claim that concerns about principal write-downs leading to strategic defaults among borrowers who already pay their mortgages on time is overstated, given how limited they believe the requirements for reductions will be in the future.

"We believe that any principal write-downs will likely be just for mortgages that are modified through the HAMP principal reduction alternative," the analysts wrote. "Under the program investors are partially compensated for writing down principal on delinquent underwater loans. The administration recently raised the compensation levels to 18 to 63 cents on the dollar from six to 21 cents earlier."

The report says GSEs partake in HAMP, but not HAMP PRA. With the introduction of HAMP PRA into the write-down equation it will be easier for servicers to "meet the net present value test" in a manner that is positive for the investor, the report said.

KBW says PRA has been tied to HAMP for a while and there is no evidence that borrowers are defaulting just to get a principal write-down.

"We believe that this potential change is likely to be a modest positive for the mortgage market," KBW concluded. "There should be no impact on agency MBS prepayment speeds as this should only impact delinquent loans that are already repurchased out of pools. We believe that the impact on mortgage servicers will be a net positive. While PRA modifications reduce loan balances which reduce initial servicing fees, they should increase the duration of the servicing assets, which should result in positive NPV for servicers."

The idea of allowing principal reductions has spurred an ongoing controversy, with some analysts claiming a move would do little to truly aid the fledgling housing market. Critics see principal reductions creating a moral hazard with taxpayers landing on the hook for writedowns.  

Anthony Sanders, a professor at finance for George Mason University, pushed back against the idea of GSE principal writedowns, saying the market will eventually correct on its own. He asked on his blog earlier this year that "if we do this, what investor or lender will want to lend in the residential mortgage market?"