A U.S. House panel began debating legislation Tuesday to allow judges to modify mortgage loans for people in bankruptcy, after a key Democrat agreed to changes narrowing its scope.

The legislation, which is progessing quickly in Congress, would amount to the most aggressive step yet by the federal government to help troubled borrowers hang on to their homes. The banking industry warns that it will raise mortgage costs for all other borrowers.

"While bankruptcy reform may not provide all of the answers to this crisis, surely it provides a common sense and practical approach to helping stop the spiral of home foreclosures," said Judiciary Committee Chairman John Conyers, D-Mich., the bill's House sponsor, in opening remarks.

Under the legislation, borrowers could have the principal balance on their home loan reduced by a bankruptcy judge - a move known as a "cram down." Current law allows cram downs for mortgages on vacation properties, but not for those on primary residences.

After stalling in Congress last year, the legislation has gained traction in recent weeks due to the shift in power in Washington and the growing perception that mortgage servicers have not done enough to help strapped borrowers.

House Speaker Nancy Pelosi, D-Calif., said Thursday the measure was a "very high priority" that could move soon as part of the economic stimulus legislation or as a stand-alone bill. It is expected to pass the Judiciary Committee on Tuesday in a party-line vote.

In key concessions to the banking industry, Conyers agreed to limit court-ordered modifications only to existing mortgages and to require that borrowers contact their lender at least 15 days before filing bankruptcy. Citigroup Inc. (C) had demanded the changes in exchange for throwing its weight behind the bill, a move that angered the rest of the industry.

Conyers also agreed to require recipients of cram downs who resell their home within five years to share the proceeds with their lender. He also added language dissuading bankruptcy judges from cramming down federally insured mortgages.

Guarantees on mortgages insured by the Federal Housing Administration, the Veterans Administration and the Department of Agriculture do not apply if the mortgages are reduced by court order.

Though banking lobbyists favor the changes, they remain staunchly opposed to the legislation.

"The housing market is already contracting and enactment of cram-down legislation would make things even worse by injecting more risk into the mortgage market, making it harder and more costly for people to buy and sell homes," a coalition of industry groups wrote in a letter to Conyers and Rep. Lamar Smith of Texas, the panel's top Republican.

They warned that court-ordered modifications would trigger more losses at Fannie Mae (FNM) and Freddie Mac (FRE), which own or guarantee more than $5 trillion of U.S. mortgages. Those losses would flow through to the U.S. government because it has agreed to pump money into the firms to keep them solvent.

Industry lobbyists also argued that mortgage servicers would shun federally-insured loans because, despite Conyers' changes, the legislation doesn't protect such loans from being crammed down by the courts.

Panel members were moving toward consensus on a Republican amendment barring people who committed mortgage fraud from receiving court-ordered modifications. However, several other GOP amendments to limit further the scope of the bill failed.

The panel voted against including language to require borrowers to complete credit counseling before receiving court-ordered modifications.

It also rejected a Republican amendment to impose criteria for how bankruptcy judges modify mortgages, including requiring them to target modifications such that borrowers' monthly mortgage payments are no less than 31%, and no more than 38%, of monthly income.

The panel also rejected a Republican amendment, offered by Rep. Trent Franks of Arizona, to limit court-ordered loan modifications just to mortgages originated between Jan. 1, 2004, and Dec. 31, 2007, during the peak of the sub-prime boom.

-By Jessica Holzer, Dow Jones Newswires; 202-862-9228; jessica.holzer@dowjones.com

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