Great question! This is one of those passages in Scripture that causes many first-time readers to choke a bit and say, "Wait -- what??" In fact, some people are positively disturbed by the possiblity that the Lord would subject one of his servants -- one of his precious messengers, no less! -- to such a shameful assignment. It is no surprise that some translators try to "soften" it somewhat and make it less objectionable. Are such translations warranted? From my point of view, the answer to this question must take into consideration both lexical and contextual indicators.
From a lexical standpoint, the word in question (עָרוֹם) is used 16 times in the Hebrew Scriptures. Many of those very clearly refer to being "naked as a newborn baby" (Job 1:21; Eccl 5:15), such as Adam & Eve in the Garden (Gen 2:25). Other references are not as definitive; i.e., they could feasibly be construed to mean "stripped to one's underclothes" (e.g. 1 Sam. 19:24, Amos 2:16), but it is by no means obvious from the context that such an interpretation is intended. In fact, it is important to note that not a single one of the references gives any definitive indication of underclothes or partial garments. (Unlike the Greek word for "naked (γυμνός), which clearly does have that semantic range; cf. Jn 21:7. But that is a different language, so it really bares no weight here.) So, based on the usage of the word itself, the evidence clearly leans toward "completely naked". Although, it should be pointed out that, in the one other reference to somebody prophecying without clothes on (King Saul, in 1 Sam. 19:24; same word there), we're told the on-lookers were more shocked by his prophecy than by his attire. Perhaps they were somewhat accustomed to the eccentricities of the prophets. Indeed, according to Isaiah himself, it was not uncommon in those days to see poor people naked (Isa 58:7).
On the other hand, however, there are some contextual clues that might modify this conclusion somewhat: First, we are told (twice) that Isaiah was "naked and barefoot". The addition of the word "barefoot" is interesting. As Young points out: "Had he been completely naked, there would be no need for this additional description" (source, p. 55). Furthermore, we find out just a few verses later that the actual event which Isaiah is symbolically foretelling is the capture of the Egyptians, who will be led away "with bared buttocks" (Isa 20:4; i.e., not entirely naked). Subjecting prisoners of war to such shame was not uncommon in that region (cf. 2 Sam 10:4). Since this is what Isaiah is predicting, it would make sense that his physical representation would match the condition of those captives exactly. Taken together, these two contextual indicators may suggest that, when Isaiah was commanded to "loose the sackcloth from [his] waist", it may have been only the lower half or the back half of his garment that he was to remove. In any case, it is almost certain that, at the very least, his wardrobe adjustment included a bare butt. But whatever the outfit looked like, it was certainly intended to be a graphical and jarring prediction of a shameful humiliation. Isaiah was not merely stripping down to a tank-top and boxers.
So I can't say my answer is conclusive, but I do believe it is clear that God wanted to grab the people's attention in a shocking and unforgettable way. There is no Biblical warrant to suggest that Isaiah wasn't exposing far more than you or I would ever be comfortable doing. I suppose the cultural implications of his day may not have been quite as objectionable as it would be today if your pastor showed up Sunday in nothing but a g-string, but there is no question that this was a humbling (if not humiliating) assignment for Isaiah. Make no mistake: God's call on a man's life is disruptive, and His commission expects total obedience. Isaiah is an example of a man who was willing to say "Yes" to his King no matter the cost to his own personal reputation or respectability.