Though uncertainty over government plans to spur mortgage modifications has hurt the value of nonagency securities, an increase in the use of principal forgiveness could generally be favorable to investors in senior bonds, according to analysts with Barclays PLC's investment bank.

Modifications of loans in bonds reflected in Markit's benchmark ABX indexes for 2006 and 2007 increased to a monthly rate of between 0.01% and 0.018% of outstanding balances in September, from close to nothing at the beginning of last year, according to a report the analysts released Monday.

Almost all the modifications involved adding missed payments to loan balances or interest rate reductions.

While "principal forgiveness remains taboo among many servicers" because of contractual restrictions, a government guarantee of modified loans as outlined by Federal Deposit Insurance Corp. Chairman Sheila Bair in testimony on Capitol Hill last week could remove a significant impediment by protecting investors from further losses if a restructured loan is liquidated.

"At this point, it seems rate reductions have run their course in tempering loan payments, and more extreme measures such as debt reduction may be in order to reach borrowers more deeply in trouble," the report said. Also, with more than $1 trillion in interest-only and pay-option adjustable-rate mortgages set to undergo increases in monthly payments of 40% to 80% in the next few years, "servicers will have to take a different approach."

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