Mortgage lenders battling legislation to allow homeowners to reduce their mortgage principal balance in bankruptcy have found an unlikely ally in the Obama administration.

President Barack Obama, who supported the measure on the campaign trail, has included it in the housing plan he unveiled this week. However, he proposed changes that could sharply curtail its impact, a move that banking lobbyists have seized as ammunition in their fight against the bill.

"The president's proposal goes a long way to bridge the gap between the sides on the issue," Financial Services Roundtable Senior Vice President Scott Talbott said.

The House next week may vote on the measure as part of a housing package.

Under the legislation, borrowers would be eligible to have a bankruptcy judge reduce the principal balance on their home loan, a move known as a "cram down." Current law allows cram downs for mortgages on vacation properties, but not for those on primary residences.

Proponents contend it will act like a stick, spurring mortgage servicers to complete more loan modifications. Meanwhile, the banking industry warns that it will raise mortgage costs for all borrowers.

President Obama this week reiterated his support for the legislation, which could hit the House floor as soon as next week. But the administration has signaled that it views court-ordered modifications as a last resort and has proposed a raft of incentives for mortgage servicers to complete voluntary loan modifications.

A fact sheet released by the administration called cram down an option "for borrowers who have run out of other options." The administration wants to limit cram downs to mortgages no larger than those that Fannie Mae (FNM) and Freddie Mac (FRE) can buy "so that millionaire homes don't clog the courts."

It also proposed changes so that the Federal Housing Administration and the Veterans Administration would pay claims against crammed-down amounts of mortgages they insure.Industry officials believe such a move would prevent investors from fleeing such loans.

But, most importantly, the administration said borrowers must certify that they have complied with requests from mortgage servicers to furnish information necessary for a loan modification. Banking lobbyists argued this is a crucial change from current legislative proposals, which only require borrowers to certify that they attempted to contact their lender regarding loan modifications before filing for bankruptcy.

The industry welcomed the proposals, saying they would likely curtail demand for judicial modifications, if they were legalized. Requiring borrowers to supply information to mortgage servicers before heading to bankruptcy court would increase the chances of a voluntary loan modification, they said.

Lobbyists are now arguing that the bankruptcy measure needs to be softened lest it cripple the administration's effort to spur voluntary modifications by mortgage servicers by providing financial incentives.

"Otherwise, you will have homeowners confused about which program to use, or worse, gaming the system. That would undercut both programs," Talbott said.

They point out that loan modifications under the Obama plan are likely to be far more aggressive. Bankruptcy judges are prohibited from lowering interest rates on secured debt below market rates or reducing principal below an asset's market value.

Neither apply under the Obama plan, which would provide incentives for servicers to change the interest rate on a modified loan to as low as 2%, well below market rates.

Proponents of the cram-down legislation have long argued it should be a last resort for borrowers, who would face a host of penalties, including badly damaged credit, if they file for bankruptcy.

The House could consider cram-down legislation next week in a proposed housing bill that also includes changes to the Hope for Homeowners program. This program began last fall to help strapped borrowers to refinance into more affordable loans backed by the government.

The Senate appears to be moving on a slightly slower track, however, according to a Senate aide.

"We are working to get everyone on the same page and crafting a seamless package that could move quickly," the aide said.

Eric Stein, senior vice president for government relations for the Center for Responsible Lending, said requiring borrowers to certify they had supplied essential information to mortgage servicers wouldn't weaken the legislation.

However, he warned against piling on additional borrower requirements, saying they could slow down a process intended to be speedy and objective.

"If you require a mini evidentiary trial before every case, that's really going to clog up the courts," Stein said.

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