The prospect for principal reductions as a mortgage modification alternative has never looked as promising as it has with a number of important housing announcements over the last few weeks. The Federal Reserve's housing white paper, for instance, highlighted the need for more attention on principal reduction modifications, and it was featured again in the president's housing plan.

Even the recent mortgage foreclosure settlement with the state attorneys general earmarked about $10 billion of the settlement for principal reduction and another $5 billion for other forms of homeowner assistance. However, this landmark settlement along with the other housing initiatives thus far has not directly addressed the issue of moral hazard.

Principal reductions may have merit in certain circumstances for circumventing foreclosure of distressed borrowers, but society and taxpayers could eventually pay a high cost by directly subsidizing activities that incent moral hazard. This argument is not new to the principal reduction debate, but what has had less discussion are mechanisms for mitigating moral hazard and financial incentives to lenders to use principal reductions that also ensure such programs impose no cost to taxpayers.

The first step to accomplish these objectives for principal reduction modifications is to restructure the mortgage contract to allow for a shared appreciation mortgage between the lender and the borrower. The actual terms of the shared appreciation mortgage could vary, but let's assume the home is worth $200,000 and the lender is willing to forgive $20,000 in principal on the original loan. By entering into a shared appreciation mortgage, the borrower gets significant payment relief while also allowing the lender to benefit from appreciation in the home over time.

In one form of this structure, the shared appreciation mortgage could have a cap set at the amount of principal reduction to the lender, after which the borrower retains all remaining appreciation. Significant flexibility in such a structure allows a variety of alternative sharing arrangements. Such a proposal has been introduced in Congress by Rep. Menendez from New Jersey, which if passed would be for a two-year trial period and only for loans backed by FHA, Fannie Mae or Freddie Mac. The shared appreciation mortgage has also attracted the attention of Ocwen Financial, a loan servicer that introduced their own variation of the product to delinquent borrowers in an effort to combat moral hazard.

The next step in the process involves a private-public financing arrangement between the federal government and lenders. To incent lenders the government could provide participating lenders with funding to cover writedowns on principal reduction modifications with the lender entering into an agreement to repay the obligation over a specified period of time. The proceeds from the shared appreciation mortgage would provide the funding for repaying the note.

Such a combined structure has several advantages. First, it mitigates moral hazard for borrowers as there is no free lunch. Borrowers entering into such arrangements realize that the lender will benefit from any appreciation up to the amount of the principal reduction.

Second, lenders will be more willing to engage in principal reductions if the financial impact of a writedown can be softened.

Third, the program is paid for largely through appreciation of homes over time and not taxpayers by way of the shared appreciation mortgage coupled with a financing arrangement established between lenders and the government.

The use of net worth certificates during the thrift crisis is an example of the kind of financial arrangement that could be adapted in concept to further incent lenders to engage in principal reductions. The mechanics of net worth certificates enabled the FDIC to buy these instruments from banks in exchange for issuing FDIC senior notes to the banks at the same rate and term (7 years). As a result there was no direct cash outlay. Such a timeframe would be generally consistent with the appreciation needed to pay back the government.

There would certainly be a host of operational issues to overcome that would plague any effort to reduce principal, such as what to do about second liens and accounting treatment of shared appreciation arrangements and the principal writedown financing, but the advantages of such a program could accelerate the use of principal reductions while mitigating moral hazard and taxpayers costs.

Clifford Rossi is an executive-in-residence and Tyser Teaching Fellow at the University of Maryland's Robert H. Smith School of Business. He has held senior risk management and credit positions at Citigroup, Washington Mutual, Countrywide, Freddie Mac and Fannie Mae.