ORLANDO, Fla. -- Many in the lending industry were taken abackwhen Federal Reserve Chairman Ben Bernanke chided lenders to thinkabout forgiving a portion of outstanding mortgage debt.

Bernanke's speech at the Independent Community Bankers ofAmerica's Annual Conference on March 4 marked the first time hespoke of lenders writing down the principal owed on loans as ameans of stemming the current flood of foreclosures. "I wassurprised when I saw that," said CUNA Economist Bill Hampel. "Ithink this was more moral suasion on the part of the Fed. It seemsto be clear evidence that the problem has become more serious, andit could be evidence of frustration."

"In recent mortgage vintages, small down payments were combinedwith other risk factors, such as a lack of documentation ofsufficient income to make the required loan payments," saidBernanke, noting weak underwriting principles as one reason for theproblems. But the unexpected slump in home values--after homeownershad borrowed heavily against the equity in those homes--has madefor a cascading crisis that has forced the Fed to pump more moneyinto the credit system to shore up shaky markets. Because borrowerswith little or no equity are more likely than others to fall behindin their payments, the large number of outstanding mortgages withnegative amortization features may exacerbate the problem, hesaid.

"This situation calls for a vigorous response," Bernanke said."Measures to reduce preventable foreclosures could help not onlystressed borrowers but also their communities and, indeed, thebroader economy. At the level of the individual community,increases in foreclosed-upon and vacant properties tend to reducehouse prices in the local area, affecting other homeowners andmunicipal tax bases. At the national level, the rise in expectedforeclosures could add significantly to the inventory of vacantunsold homes--already at more than two million units at the end of2007--putting further pressure on house prices and housingconstruction."

The Fed chairman spoke of loan workout efforts and refinancingwhere possible, but failing that, "the next-best solution may oftenbe some type of loss-mitigation arrangement between the lender andthe distressed borrower. Indeed, the Federal Reserve and otherregulators have issued guidance urging lenders and servicers topursue such arrangements as an alternative to foreclosure whenfeasible and prudent." But even that option might not be enough,Bernanke conceded, given the realities of the securitizationprocess and the constraints faced by servicers.

In this environment, principal reductions that restore someequity to the homeowner may be a more effective means of avoidingdelinquency and foreclosure. "Lenders tell us that they arereluctant to write down principal," Bernanke said. "They say thatif they were to write down the principal and house prices were tofall further, they could feel pressured to write down principalagain.... But when the mortgage is underwater, a reduction inprincipal may increase the expected payoff by reducing the risk ofdefault and foreclosure." Essentially, Bernanke recommended thatlenders perform a cost-benefit analysis between holding foreclosedreal estate against the value of accepting less money andstabilizing communities by keeping people in their homes.

The idea of lenders becoming more flexible on loan terms struckNAFCU Chief Economist Tun Wai with some amusement. "This wholebusiness of renegotiating terms, extensions and workouts--well,credit unions have been doing that sort of thing all along. Banksare just now discovering that they have to do it? We have a lot ofpeople in this country right now that are really hurting. Thisproblem is pervasive and it's spreading. What Bernanke and the Fedare trying to do is prevent a bottleneck as the numbers rise. He'surging lenders to do something now, to take a look at the long terminstead of the short term."

Risking Moral Hazard

Bernanke stressed that "solutions should also be prudent andconsistent with the safety and soundness of the lender. Concernsabout fairness and the need to minimize moral hazard add to thecomplexity of the issue. We want to help borrowers in trouble, butwe do not want borrowers who have avoided problems throughresponsible financial management to feel that they are beingunfairly penalized."

"People who played by the rules will be asking why?" agreed Wai."It can be a mixed message. People who are leveraged to the hiltand get a reduction bring up the moral hazard issue, rewarding badchoices. But in the end, it's about what the market will bear. Justlook at the recent hearings on CEO pay. Any number of critics havesaid that [former Fed Chairman Alan] Greenspan kept rates too lowfor too long, so if you take an action now where people who madebad borrowing decisions are eventually rewarded, it sends a badmessage."

Hampel concurred. "Fannie Mae and Freddie Mac have the impliedguarantee of the government and now push is coming to shove. Thereis a moral hazard argument to be made that you shouldn't protectspeculative investors, but their behavior has had an effect onthose who didn't speculate."

Eva Weber of Boston's Aite Group said that the Fed was remindinglenders that everything, eventually, comes down to a pure businessdecision. "Getting lenders to write down principal may seem a bitmuch. I can't imagine lenders are going to jump on this." Webersaid that lenders surely don't want a glut of REOs, but neitherwill they be inclined to reduce principal in an environment wheremortgage rates are going up while home prices decline.

"The approach seems to be, 'try anything' or think about itanyway, even if the suggestion may not be taken very far. The Fedseems to be putting pressure on lenders to see if something startsto work. And while no solution will be perfect, out of a mix ofideas one may emerge," Weber said. She added that the Fed wasclearly concerned about the mortgage meltdown's effect on othersectors of the economy. "The recent employment figures show thatnothing is immune to this." Consumer confidence and spending isalso flat or declining and the stock market is fluctuatingwildly.

"The flood of liquidity the Fed is pumping into the system isn'tworking," Hampel said. "It isn't flowing into mortgage rates. Thesecurities market is still very nervous about buying any bondsbacked by mortgages."

[email protected]